An Examination of Mispricing, Returns, and Uncertainty for Initial Public Offerings

An understanding of the market for initial public offerings (IPOs) is important not only for investors and underwriters, but also for financial managers. Small, non-public firms may need this market in the future, for example. In addition, financial managers of currently public firms should understand this market since there are numerous firms going private and subsequently going public again. Also, firms are more willing to spin-off divisions to their current stockholders or allow managers to put together a leveraged buy-out that may eventually go public. Early studies of IPOs 2, 3, 8, 9, 10, 11, 12, 15, 16, 17, 18, 22 were mainly concerned with examining the profit potential for investors in these issues. The results consistently indicated that, on average, IPOs offered significant positive excess returns in the short run, and it was generally agreed that these were attributable to the underpricing of these new issues by the underwriters. Many of the studies also addressed the implication of these results for the efficient market hypothesis (EMH). The general conclusion has been that, consisent with the EMH, prices adjust rapidly to the underpricing, and investors who purchase the new issues in the after-market (i.e., a week or a month after the initial offering) do not experience excess returns. A more recent line of research (Beatty and Ritter 1, Ritter 19, Rock 20) goes beyond the empirical evidence of underpricing and sets forth theoretical arguments that explain the underpricing in terms of information asymmetry among traders. The investor (or trader) in the IPO either is ex ante about the after-market equilibrium price, or is uninformed about the price. If an IPO is underpriced, informed traders will enter orders for the issue, causing the issue to most likely be oversubscribed, and thereby requiring an allocation or rationing of the issue. Uninformed The authors acknowledge the financial support from the Jesse H. Jones Data Bank at the University of Notre Dame. We also appreciate the comments by participants in the Research Seminar at Notre Dame, and a special thanks to Robert Taggart for his comments and suggestions.