INITIAL PUBLIC

OFFERINGS
Ibbotson, Roger G. Sindelar, Jody L. Ritter, Jay R.
Background - IPO
Private limited companies or venture capital
funded project can raise capital and ensure
liquidity by going public.
Such IPOs come with risk: issuer, investment
banker, and investors.
Pricing of IPOs is difficult because there is data
insufficiency in the observable market price as
well as the lack of operational history.
The lack of accurate pricing results in pricing anomalies of
IPOs set too high the investor gets an inferior return
resulting in rejection of the offering, set too low the issuer’s
ability to raise capital is jeopardised.

(If the price is set too low, the issuer does not get the full
advantage of its ability to raise capital.
If it is priced too high, then the investor would get an
inferior return and consequently might reject the offering.)
Therefore in the absence of a robust market for IPOs ,
aspiring growth companies would have restricted access
to the public in raising capital.
The said paper examines IPO based data from the early
1970s to late 1980s in an attempt to explain anomalies in
IPO pricing.
Based on this understanding of pricing anomalies of
IPOs empirical evidence uncovers the incidence of :
Empirical Evidence
■ Unseasoned new issues are significantly under-priced
■ A number of hypothesis are there to explain the under-
pricing, but no supported explanation of IPO under-pricing.
■ recurring pattern of alternating hot and cold new issue
market.(Hot issue market have average initial returns
reaches unbelievable level)
■ The hot issues tend to be increasing in volume leading to
heavy volumes accompanied by relatively low returns.
■ The heavy issues markets then leads to initial poor
performance and light volume.
IPO process:
Background: Price at which company trades the ownership of cash, depends upon
overall market conditions, the specifies of the firm, and policies of investment
bankers.

Underwriter Methods Price

/Syndicate of
Underwriter •Issuer firm issues preliminary
prospectus
•Best efforts •In 20 days SEC review the
•-Both negotiate a offering price prospectus (Cooling off
period)
•Firm Commitment
•Prestigious •Underwriter surveys the
Underwriter • -underwriter guarantees the market and investors are
agreed amount of capital raised asked to indicate their
•Underwriters refuse
speculative issues • (Parties comply to Securities act willingness to purchase
1933) shares at some price(Offer
Price)
Setting the Price
In spite of underwriter’s surveys of market , uncertainty
remains on acceptance of the issue.
If price is set too low- issuer does not realise their full
potential to raise capital.(Issue could be withdrawn)
If the price is set too high, the firm commitment underwriter
has a financial loss because he has to lower the price to sell
the entire issue. (Issuer suffers excessive dilution of
ownership)
Empirical
Findings
■ Monthly average
initial returns are
calculated by taking
an equally-weighted
average of the initial
returns.(OTC)
■ Two period is used
1960-76(before
NASDAQ) and 1977-
87.
■ Autocorrelation is
0.62
■ Larger firms are
underpriced less
■ Speculative
issues also tend
to have offering
prices below $3
per share.
■ Another evidence
is reverse LBO. In
1980 dozen of
firms have gone
private in
leveraged
buyouts, and
went public
again with in few
years.
Research Outcomes – Theories to suggest under-pricing of IPOs
■ One of the theory suggests, underwriter has significantly better information than the issuer. In
firm commitment offers, underwriter has the incentive to set a relatively low price to ensure that
the entire issue sells at the predetermined price. Underwriter has knowledge about market-
clearing prices.
■ Another study by Muscarella and Vetusuypens examined the under-pricing of IPOs of
investments banks going public. They find that the 38 investment banks went public during
1970-87, the average initial rate was 7.1 % which can be compared to other similar size IPOs. It
was analysed that well-informed Investment bankers also appear to under-price their own IPOs
to be an “equilibrium” level of under-pricing with issuers, underwriters, and investors.
■ Alternative explanation was given by Kevin Rock, as per this some investors become informed
about the true value of a new issue, while others remain uninformed due to the cost involved in
getting the information. Underwriter is assumed not to know – how much the market is willing to
pay for the issue. Hence the stock are either overvalued or undervalued.
■ Other research explains hot and cold prices of new issues. Hot markets occur when issues are
characterised by great uncertainty and issues have to be discounted even more than usual to
attract uninformed investors. Cold markets occur when there is comparatively less uncertainty
and therefore less discounting.
Policy Implications
■ Investors should buy new issues during a hot issue
market when they are generally under-priced. Also, more
under-priced an issue harder to get and not all issues
are under-priced during hot market. In cold markets,
significantly under-priced are less likely , but they exist.
■ It also seems possible to predict which issues are most
likely to appreciate by comparing the final offering price
with the offering price range listed on the front page of
the preliminary prospectus of a firm commitment
offering.
■ When Investment bankers find unanticipatedly strong or
weak demand, they adjust the offering price, but only
partially.
■ The authors suggest that, issuers should issue in the heavy
markets that typically follow hot issue. In these periods, issuers
get highest price for their securities relative to the efficient
publicly traded price. The low number of offerings during cold
issue markets may be due to perceived lack of buyers and to the
lower multiples received by issuers.
■ Issuers should use ‘firm commitment’ offering with a prestigious
underwriter. To a certain extent the quality of the underwriter
certifies the quality of the issuer, thus increasing the price that
investors are willing to pay.
■ Finally, issuers should disclose as much information as possible
about their firm-short of divulging valuable competitive secrets-at
the time of issue.
Limitations of the study

■ Data time span is large : 28 years. In October 1987 US markets had a stock market
crash which could lead to different results altogether.
■ The study focused on only IPOs of private firms excluding close-ended mutual funds,
REITs)
■ The study is based on secondary data. So, the limitations of secondary data may
also creep in and have an impact on the present study also.
■ Data collection is categorised into prior to later to NASDAQ. Hence the statistical
errors will creep in.