Before going in details, presenting the explanations advanced for the short run IPO anomaly, it is logical to begin by a definition of this notion of “underpricing” to understand this short run phenomenon:
Early writers that have been interested in IPO market, notably Stoll and Curley (1970), Logue (1973), Reilly (1973) and Ibbotson (1975), are the first who documented that when companies go public, the price of shares they sell tends to jump substantially on the first day of trading. The first day closing price is systematically higher than the issue price at which the public offering was introduced in the market. Consequently, IPOs exhibit positive first day returns on average with no exception to the industry to which the IPO belongs, to the country and to the period and date of going public. That has been the first and the most important observation in the IPO market.
From an issuer’s point of view, this phenomenon is usually called underpricing, as it describes the additional amount of money which could have been raised by the issuer if the offer price had been set at an appropriate level. Indeed, if the issuer had been set a higher offer price for his offering shares, the issue price could have been easily accepted by the investors interested in purchasing the IPO shares, since a run up is observed on the first day of trading. The trading begins by the offer price which is less than the apparent maximum price achievable at the end of the first trading day. In a way it is an amount of money left on the IPO table from the issuers’ point of view. Therefore, underpricing is an expression used to describe the issuer point of view, as he thinks that he has not correctly valued the IPO shares, he underpriced the real value of the shares of his company.
Underpricing is estimated as the percentage difference between the price at which the shares subsequently trade in the market (the first day closing price) and the price at which the IPO shares were sold to investors (the offer price or the issue price) and at which the offering was introduced. Underpricing is suggesting that firms which go public leave considerable amounts of money on the table. The amount of money left on the table is defined as the difference between the closing price on the first day and the offer price, multiplied by the number of shares sold. In the words of Jay Ritter, this is the first-day profit received by investors who were allocated shares at the offer price. It represents a wealth transfer from the shareholders of the issuing firm to these investors. So, underpricing is a loss, a cost for the issuers that they want to minimize and a profit for the first investors that purchase and acquire the IPO shares.