Research

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UNDER-PRICING AND LONG-RUN

PERFORMANCE OF INITIAL PUBLIC

OFFERINGS IN INDIAN STOCK MARKET

Dr. S. Janakiramanan

Associate professor

Singapore Management University

SINGAPORE MANAGEMENT UNIVERSITY

(LEE KONG CHIAN SCHOOL OF BUSINESS)

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INTRODUCTION

The transition from being a private company to a public one is one of the most

important events in the life of a firm. It is also one of particular interest to institutional

investors, and the transition is facilitated through the initial public offering (IPO) process.

The IPO provides a fresh source of capital that is critical to the growth of the firm and

provides the founder and other shareholders such as venture capitalists a liquid market for

their shares. From an institutional investor's perspective, the IPO provides an opportunity to

share in the rewards of the growth of the firm.

When a firm issues equity to the public for the first time, it makes an initial public

offering consisting of two kinds of issues – the primary issue and the follow-on issue. In a

primary, the firm raises capital for itself by selling stock to the public, whereas in the followon

issue, existing large shareholders sell to the public a substantial number of shares they

currently own.

It is a well documented fact that IPOs tend to be generally under-priced, though some

issues tend to be overpriced. From the viewpoint of financial research, IPO under-pricing in

the sense of abnormal short-term returns on IPOs has been found in nearly every country in

the world. This suggests that IPO under-pricing may be the outcome of basic problems of

information and uncertainty in the IPO process, and is unlikely to be a figment of institutional

peculiarities of any one market.

There have also been various studies made to suggest the reasons for such underpricing.

From the investors’ point of view, this under-pricing appear to provide the sure and

quick profit that most dream about. Though first day return could vary, few of the issues tend

to provide a very high return over the first day. One of the examples is VA Linux which had a

first day return of 700%. It is also seen that for some of the issues, the first day return could

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also be negative. It then becomes inevitable for most investors to measure the performance

of IPOs by the short term (usually within one week of issue), as the general scheme is to buy

the shares at a low initial offering price and sell it the next day when the price increases.

Pricing of the IPOs are done by the issuers with guidance from underwriters from investment

banks. There are various ways to price the stocks but what is commonly used now is a

process called book building. It is basically a capital issuance process used in an Initial Public

Offer which aids price and demand discovery. It is also a process used for marketing a public

offer of equity shares of a company. During the period for which the book for the IPO is

open, bids are collected from investors at various prices, which are above or equal to the floor

price. The offer/issue price is then determined by the issuing company after the bid closing

date based on the various bids that have been collected. For a more detailed discussion of

book building, one can visit any of the many stock exchanges.