Undervaluation of Initial Public Offering (IPO)
The Undervaluation of Initial Public Offering (IPO)
Group members:
Maram AlDukhayyil
201001719
Farah AlDossary
200900267
Haifa Fakhro
200900855
Section: 201
Submission date: 19-12-2012
FINA 3312: Financial Institution
Instructor: Rashida Sharmin
Prince Mohammad Bin Fahd University
Fall 2012-2013
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Undervaluation of Initial Public Offering (IPO)
Table of Contents:
Exclusive Summary ..................................................................................................... 3
Introduction .................................................................................................................. 4
Literature Review ........................................................................................................ 5
A. IPO............................................................................................................................ 5
B. Process of Going Public .......................................................................................... 5
C. Agreements with Investment Bank ....................................................................... 6
D. Developing a Prospectus ......................................................................................... 6
E. IPO Allocations ........................................................................................................ 7
F. Role of Investors ...................................................................................................... 7
G. Flipping Shares ....................................................................................................... 8
H. Lockup ..................................................................................................................... 8
I. Types of Companies who engage in an IPO ........................................................... 9
J. Valuation................................................................................................................... 9
K. Why IPOs get underpriced? ................................................................................ 10
K.1. Accounting Irregularities .................................................................................. 11
K.2. Investment Banks............................................................................................... 13
L. Effect of the Under-priced IPOs on firms ........................................................... 13
M. Google’s IPO story ............................................................................................... 14
Conclusion .................................................................................................................. 17
References ................................................................................................................... 18
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Undervaluation of Initial Public Offering (IPO)
Exclusive Summary
In one time or another, firms need to raise it capital to finance new plans,
expand their facilities and operation, or as most of the cases, to start their business.
The best way that newer and weaker companies can use to raise its capital quickly, is
to engage in an Initial public offerings (IPOs).
Comparing to the performance of the market as a whole, it been founded that,
historically, IPOs had very large gains at the end of the first day. If we supposed that
the market price - that had been derived by its supply and demand - is a good
representative of the company’s value, then those large gains emphasis the fact that
IPOs is lower than the actual value of the firm (Karlis, 81, 2000).
This report mainly studies the reasons behind the massive undervaluation of
the IPO. In addition, it shows the bad effect of such undervaluation by representing a
case of company, who got harmed by it. It also illustrates the IPO in general, and the
process of it.
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Undervaluation of Initial Public Offering (IPO)
Introduction
The indirect cost of going public that is paid by issuing firm is actually the
under-pricing of initial public offerings. An expert industry at Stein, Roe & Fonham
found that IPOs were underpriced by around 16% for the past years. In fact, some of
the IPOs have been undervalued in about 200 to 400 percent from its initial first day
gain (Karlis, 81, 2000)! Hence, we assumed that it is more likely to increase in the
future. Fortunately, after the huge effects of such under-pricing, people now are more
aware of it. Especially that the News nowadays detect any fraud firms and show it
scheme, leading the company to declare bankruptcy.
This study will mainly focus on the factors that lead the large growth in the
initial gains from IPOs. It will also discuss the solution that the government
established to protect the firms from an unfair under-pricing. Lastly, before all of that
it explain the IPO briefly and its process.
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Undervaluation of Initial Public Offering (IPO)
Literature Review
A. IPO
IPO stands for Initial Public Offering, which means when a company decides
to issue stocks to the public for the first time it must engages in the IPO. The
company has the option of either issuing debt or equity. In other words, when a
company engages in IPO, it takes a lot of money and effort in issuing or purchasing
common stocks or shares to the public for the first time. The large strong companies
are the ones who usually engage in the IPO, yet smaller or weaker companies, who
seek to expand it capital, might engage, too. Further, another reason of looking to
engage in IPO, other than increasing its capital, is to become a “publicly traded”
institution.
In addition, one of the most questions that comes to our minds, why
companies or small invertors want to trade publicly? There are several reasons that let
the companies and all types of investors, the small or large, to try to go public. The
benefits of being a “publicly traded” company are numerous, but the main benefits
are, one, is improving liquidity as much as it can get, leading the company to reach a
higher value. Second, is that they will have the ability to make acquisitions. Finally,
being publicly traded often leads the offering of a company’s security to a higher
price in later offerings (Investopedia US, n.d).
B. Process of Going Public
In order for firms to engage in an IPO, there are several steps required first.
The first point or step in engaging in an IPO is to hire an investment bank and talk or
negotiate the contract to state the type of the stocks or bonds of securities. When the
firm gets the capital amount that should be raised and the details of the actual
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Undervaluation of Initial Public Offering (IPO)
underwriting agreement, then the company and the bank investment can now
determine the structure and the rolls of the contract. There are generally two types of
structured agreement and they are totally different (Bratton, 2002).
C. Agreements with Investments Banks
The first type of the structured agreement called the firm commitment
agreement. Which is basically when an underwriter guarantees that a certain capital
amount will be raised by buying the whole or the entire offer and reselling them to the
public. Whereas on the second type of the structured agreement is the best effort
agreement. It is mainly about where the underwriter starts to sell the stocks or bonds
to a company without guaranteeing of a specific price or percentage that shows how
much it will increase or decrease. When they finally reach to agreement, the bank
investment files a registration statement to the SEO, which is the Securities and
Exchange Commission (Espinasse, 2011).
D. Developing a prospectus
The registration statement has all the information about the offering itself and
other information about the company that will issue the stock. This information
include the financial statement, a background of the management, and any issues such
as legal issues that the company might be involved in. After finishing the registration
statement with the SEC, they will be in the “cooling off” period. Moreover, the SEC
will start investigation during the cooling off period. It will check if the provided
information about the company is completed and clear. When the investigation is
done properly, they will approve the offering and give the company an effective date
for the bond or stock to be offered to the public. Additionally, while the SEC are busy
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Undervaluation of Initial Public Offering (IPO)
in its investigation, the underwrite and the firm will put together the initial prospectus
which known as “red herring” (Espinasse, 2011).
E. IPO Allocations
As we see the red herring gives and allows both sides, the underwriter and the
company, to build and have the interest in issuing with institutional invertors. Thus,
the underwriter puts the price, which is determined by the current market shoes or
conditions. And when the effective date reserve or arrives, the firm can start selling
their stocks and bonds on the Stock Exchange Market. Underwriter can also put an
IPO allocation before the date arrives.
If an underwriter believes that the IPO is valued correctly. The firm could
perform an IPO allocation for interested institutional clients. They do that by having
an account with one of the investment banks that is involved in the underwriting
syndicate. While the stock begins publicly traded investors could get involved (Lee,
n.d).
F. Role of Investors
Every individual investor is hoping to get in the IPO, yet they carefully search
about the firm’s information before considering participating in it. When investors
want to research about the IPO, the first step they should start their research with is
the company that issued the stock. After that, invertors should be able to answer such
questions:
1. Who is the management of the group or team?
2. Where within the company the capital raised will be used?
3. Who was the investment bank that performed the underwriting?
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Undervaluation of Initial Public Offering (IPO)
The smaller invertors usually ignore searching for the company’s financial
statement, the management and the background or history of it. This lead them to be
in significantly higher risk. Another important element that investors must consider is
the lockup period - a discussion will be provided later - and the market price per share
(Karlis, 81, 2000). To illustrate what Lockup is, a person must know what the flipping
shares is.
G. Flipping Shares
Flipping shares is a term that refers to the attempts by investors to purchase
the stock at its offer price and sell it again shortly afterwards gaining a large amount
of money. The investors who do such behavior are usually in the black list, and they
cannot engage in future public offerings. The reason behind that is because investors
who engage in flipping are only interested in capitalizing their money from the initial
return that occur for many IPOs and have no intention of investing in the firm. In
short, the market price of the stock might decline shortly after the IPO, if many
institutional investors flip their shares (Madura, 237, 2008). Thus, to prevent that,
firms invented the Lockups.
H. Lockups
Lockup is the attempt to guarantee stability in the stock’s price after the
offering and it done by the underwriter. Prohibiting the stock sale for a specific period
of time is the main idea behind the lockup. This time can range anywhere from 90
days, as a minimum, to 2 years. According to the SEC rule 144. Employees are free to
start selling their stocks when the lockup is expire. This usually drives the price stock
into a steep downturn (Madura, 235, 2008).
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Undervaluation of Initial Public Offering (IPO)
I. Types of Companies who engage in an IPO
A company maybe falls between these two categories: a publicly held or a
privately held company. The different between these two is the that privately held
companies is normally had a little or a few share holders and its not required to fully
disclose a company information (Lee, n.d). Where as the public companies usually
have thousands of shareholders and it is regulated by the SEC. the SEC required such
companies to have a board of directors, and they are obligated to report the financial
conditions about the company quarterly (Madura, 233, 2008).
J. Valuation
Since our topic is about undervaluation of IPO’s, an illustration of the
valuation process will be covered first. And given that the valuation of the stock price
is what will drive most of the demand and the offer prices that are paid by investors, it
is clearly a significant step for all issuers to consider. As a result to the enormous
number of different corporations with different fields, there is without a doubt various
methods to evaluate a corporation’s stocks prices. Price-to-growth multiples,
Normalized multiples, Dividend and distribution yields and many more are an
examples for such methods. Yet, the most frequently valuation technique used among
organizations is the simple Price-to-earnings (P/E or PER) multiple. In further details,
the P/E is basically the price per share divided by earnings per share (EPS). Or
another method to estimate it is the expected market capitalization divided by forecast
earnings. Suffice it to say, it is a very simple technique and does not require a deep
analysis to figure it out (Espinasse, 108, 2011).
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Undervaluation of Initial Public Offering (IPO)
K. Why IPO’s get underpriced?
Before start listing the reasons behind the undervaluation of IPO’s, a person
has to know what is the definition of under-pricing first. It basically means when the
pricing of an IPO is lower than the market value. To illustrate more, the stock is
considered to be undervalued when the offer price of that stock is below the first trade
price. To clarify it more, here is the mathematical rule for IPOs undervaluation:
Under-pricing = (First-day closing price – Offer price) ÷ Offer price × 100%
In essence, how much investors are willing to pay is showed by the first-day
closing price. And since corporations stocks’ prices has a lower offers than what they
could have gained, the money left on the table shows the riches movement from the
firm to the new shareholders (Booth, n.d).
Luckily, sooner or later the laws of supply and demand will force the stock
price to go back to its actual value. That is why this condition is usually temporarily
(Investopedia US, n.d). Historically, IPOs had incredibly large initial first day gains
comparing to the performance of the rest of the market. There are several reasons
behind such under pricing. It will be mentioned below.
K.1. Information Asymmetry
The main cause of the undervaluation of IPOs is informational asymmetry.
The theory of the information asymmetry believes that the Pricing of IPO is a result of
information differences. This theory has several forms, but the most significant one
among those forms was established by Kevin Rock, approximately twenty-five years
ago. His theory in short was about the uninformed and informed investors, they are
called “noise traders” (Madura, 319, 2008). He said that the uninformed investors bid
without considering the IPO’s value. Whereas bidding in informed investors depends
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Undervaluation of Initial Public Offering (IPO)
on the offerings that they believe it will benefit them. Hence, if a poor IPO occurs,
only the naïve investors will bid on it. Thus such investors will lose a huge amount of
money and leave the IPO market at the end. And since households as a group
represent the largest sector in demanding stocks, they usually do not have the
information about the IPOs so they are classified as uninformed investors (Madura,
28, 2008). To prevent that, the underwriter re-prices the IPO to a lower value in order
to make the uninformed investors bid again causing the undervaluation of IPO. So,
the undervaluation of IPOs will be reduced when the bidding is between the informed
investors only (Davidoff, 2011). Hence, if the information about company that wants
to issue stocks is more freely available, the under-pricing of their stocks will be lower
than a company with no clear information.
K.2. Accounting Irregularities
One of the main causes of information asymmetry and under-pricing is when
corporations manipulates their financial statement and represent it a strong firm with
good capital where in reality it is a weak firm. Thus, investors in such corporations
had wrong information about the firm. For the past years, many companies used fake
accounting methods to create better financial statements. Enron, Tyco and WorldCom
are famous examples for companies that did such behaviors. In addition, people who
invest in those firms were having difficulties to determine the true financial
conditions of those companies and in observing their performance. In short, many
factors ware the reason behind the investors’ limitation of monitoring such firm.
Accountants distorted the financial statements, auditors making many mistakes in
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Undervaluation of Initial Public Offering (IPO)
auditing, and failing on checking the auditors’ performance of such firms by the audit
committees are examples for such reasons.
To ensure more accurate information about the financial condition of any firm
to the investors, an act called Sarbanes-Oxley applied in 2002. The act contains many
specific terms. To explain it in details, one of the terms was about preventing the
auditing of any client firms by any public accounting institutions. A client firm is
basically any firm who its chief executive officer “CEO”, chief financial officer
“CFO” or any other employees with the same job field worked at the accounting firm
for the past one year from the audit. One of the other terms was mainly about the
audit committee. First, an audit committee consists of group of accountants making
sure that the audit is performed fairly in an unbiased manner. The act states that the
board members of a firm are permitted to be in the audit committee. The reason
behind this term is the fact that outside board members tend to know and serve
shareholders interests better than inside board members, who are part of the
company’s management and might have a conflict interests (Madura, 249, 2008). To
show how such manipulating, cheating and lying can devastate many lives and firms,
a discussion about Enron scandal will hopefully be convincing enough.
Enron is an American energy company established in Huston, Texas. It was
the America’s seventh largest company and the employees were approximately
21,000 in around forty different counties. All of that success was achieved in around
fifty years only (BBC News, 2002)! Yet, “the rope of a lie is short.” – an Arabic
saying. The huge accomplishment of Enron Corporation turned out to be a huge scam,
too. Enron's $63.4 billion of assets made them to become the largest bankruptcy
reorganization at that time in American history and been classified as the biggest audit
failure (Bratton, 2002). The effects of their lies about their profits were massive! $11
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Undervaluation of Initial Public Offering (IPO)
billion dollars of loses by the shareholders when Enron’ stock price, which was US
$90 throughout mid-2000, fall to become less than US $1 by the end of November
2001. The Securities and Exchange Commission (SEC) started an investigation that
ended with Enron declaring bankruptcy on December 2, 200 (Benston, 2003).
K.3. Investment Banking
To insure that the entire issue can be placed and covered, the investment
banking institutions intentionally underwrites the IPOs underpriced. In fact,
underwriters are supported when they err or made a mistake when pricing IPOs, if it
is on the low side of course (Madura, 288, 2008). Yet, Investment Banking is
considered one of the important causes of undervaluation of IPO. In fact, it has been
found that 40 percent of undervaluation of IPOs is reduced when investment banks
underwrites a client firm’s IPO (Davidoff, 2011)! This act is obviously illegal and
many strict punishments have been found to prevent the under-pricing as a way to
benefits them, investment banks, and their client firms.
L. Effect of the Under-priced IPOs on firms
The effects of undervalued IPOs are very dangers to the issuing firms. In fact,
the amount of money left on the table to new shareholders, caused by under-pricing
IPOs, is two times the fees paid for direct underwriting. Unfortunately, in many IPO
institutions, such amount of money can be equivalent to for several years of operating
profit (Booth, n.d). Thus, we believe the best way to present such horrible effects is
by providing the Google’s case as an evidence.
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M. Google’s IPO story
On 18 of august in 2004 Google issue stock to public. It took the media
attention because of Google's name recognition. They gain $1.6 billion from the
initial public offering, which is more than the value of America online, Microsoft,
Netscape, and amazon.com IPOs together! Larry Page and Sergey Brin are the
founder of Google. They sold a portion of their shares within IPO for $40 million
each, and the retained shares are $3 billion each.
Usually investors determine the value of stock to see if it's worth investing in
it. What happened with Google is that some investors used Yahoo as benchmark,
because Yahoo stock is famous and it's traded since 1996. To determine the stock
price of Google, investor multiplied Google earnings per share by yahoo's price earnings ratio. Unfortunately, this method has some limitations. The first limit is that
Yahoo and Google have a different type of business; also some investors see that
Microsoft is a better benchmark than Yahoo. The second issue is that they have
different accounting methods. Hence, it will be wrong when they estimate the value
by comparing the earnings of the two firms.
So we can conclude that stock valuations are subject to error, especially for
IPO. The reason of that is that the stock price is not determent in the past. In Google
case they expected that its stocks would sell between $118 – and $135 per share, but
they had it below $100 before the IPO. That happened because the firm that issue the
stock is unsure of its market value and it's difficult to know what investor will be
willing to pay for the new issued stock.
Moreover, the auction process in google’s IPO was different than other firms
because they use a Dutch auction process instead of the relying almost exclusively on
institutional investor. The Dutch auction process allowed all investors to put a bid for
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Undervaluation of Initial Public Offering (IPO)
the stock at a specific deadline. After that they determined the minimum price at
witch it would be able to sell all of the shares, the bid that equal or above the price
were accepted and the bids that under the price are rejected. In Google IPO there was
more than 30 companies that intermediaries between Google and the investor.
The different between the auction process and the traditional IPO is that the
investment banks have more responsibility to place the shares. In addition, they tend
to focus on placing the shares with institutional investors. But when using Dutch
auction process, Google allowed individual investor to participate directly in the IPO
in order to increase their profits.
Moreover because of the difficult registration process required some investor
decided not to submit a bid during Google Duct action. They did that because they
needed to complete forms to prove, to the investment bank, that they were financially
qualified. Yet, Google had a great benefit of the auction process because it is lower
than the traditional IPO. Further, this process has saved Google about 20 million in
fees. Also it's allowed Google to attract a diversified investor base. So we can say that
auction processes are successfully worked with firms that are not well known to
individual investors as Google.
The results of Google Dutch auction resulted in a price of $85 per share.
Meaning the investors who bided accepted the paid, which was $85 per share. Google
was able to sell it for 19.6 million shares at that price witch generated proceeds of
$1.67 billion. But Google hoped to sell the shares in between $118 to $135 per share.
If they could sell it for $120 per share they would have gained $686 million in
proceed from IPO (Madura, 238, 2008).
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Undervaluation of Initial Public Offering (IPO)
Finally, In June 2007, Google was able to sell it stock for about $500 per
share, which is more than five times its original price in 2004. From that we can
conclude the harms effect of IPOs under-pricing by showing the differences of the
Google’s stock price in 2004 and 2007.
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Undervaluation of Initial Public Offering (IPO)
Conclusion
This paper represents the undervaluation of the Initial Public Offerings (IPO)
by describing what is the IPO in the first place. Followed by an explanation on how
can companies go from private companies to become a public company, in addition to
the specific details about the process of IPOs. Next, in order to explain the reasons
behind the under-pricing of the IPOs, an illustration of the valuation process was
provided first. The Information Asymmetry, the Accounting Irregularities, and the
Investment Banks were the three main reasons behind the undervaluation of IPOs that
we found. Subsequently we indeed the report by giving an example of a company that
been harmed by its undervalued IPO, which was the Google Company.
In addition to all of that, the paper discussed a new interesting term such as
Lockups and flipping shares. And it also mentioned the types of companies that
engage in an IPO and its reasons. Hopefully, the paper provided the sufficient
information to all the readers who are interested in the IPO and its undervaluation in
particular.
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Undervaluation of Initial Public Offering (IPO)
References
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Benston, G. (2003). The Quality of Corporate Financial Statements and Their
Auditors before and after Enron . Policy Analysis, 1(497). Retrieved
December 17, 2012, from
http://www.cato.org/sites/cato.org/files/pubs/pdf/pa497.pdf
Booth, L. (n.d.). Initial Public Offering (IPO) Underpricing - Full Article QFINANCE. Financial resources, articles, concepts and opinions from
QFINANCE - QFINANCE. Retrieved December 18, 2012, from
http://www.qfinance.com/financing-best-practice/the-cost-of-going-publicwhy-ipos-are-typically-underpriced?full
Bratton, W. (2002). Enron and the Dark Side of Shareholder Value. Tulane Law
Review, 1. Retrieved December 17, 2012, from
http://ssrn.com/abstract=301475
Davidoff, S. (2011, May 27). Why I.P.O.'s Get Underpriced - NYTimes.com.
Mergers, Acquisitions, Venture Capital, Hedge Funds - DealBook NYTimes.com. Retrieved December 18, 2012, from
http://dealbook.nytimes.com/2011/05/27/why-i-p-o-s-get-underpriced/
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Undervaluation of Initial Public Offering (IPO)
Espinasse, P. (2011). Ipo a global guide. Hong Kong: Hong Kong University Press.
Investopedia, US. (n.d.).“ Educating the world about finance. Retrieved December
18, 2012, from
http://www.investopedia.com/terms/u/underpricing.asp#axzz2FHleSJq9
Karlis, P. (2000). IPO Underpricing. The Park Place Economist , 8(1). Retrieved
December 17, 2012, from
http://digitalcommons.iwu.edu/parkplace/vol8/iss1/17
Lee, N. (n.d.). The Initial Public Offering (IPO) Process | Mergers & Inquisitions.
Understanding Investment Banking | Mergers & Inquisitions. Retrieved
December 18, 2012, from http://www.mergersandinquisitions.com/initialpublic-offering-process-ipo
Madura, J. (2008). Financial institutions and markets (8th ed., international student
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