IPO Underpricing

and Its Effect on

Main Stock
Markets
MPF 753

Ruslan Temniuk ID noPasan Malru ID no - 214380176

Contents
Executive Summary...........................................................3
Introduction...................................................................... 3
Short run IPO underpricing in Australian share market........3
Theories of IPO Underpricing.............................................6
Asymmetric Information Models Winner`s Curse Model...7
Behavioural Explanations Cascades...............................7
LinkedIn IPO Underpricing - 2011..................................8
IPO Underpricing in US and Australian Share Market...........8
Short Term IPO Underpricing in Asia Pacific Malaysian
Stock Market....................................................................9
Methodology...............................................................9
Analysis of the data...................................................10
Conclusion......................................................................13

Executive Summary
Every company in today`s world is expanding. The best and most
profitable way for a company to expand and get public equity is
going public. When companies go public for the first time and in
their IPO, they often face underpricing. Winner`s Curse & Cascade
theory of IPO underpricing can be commonly seen almost every
stock market worldwide. LinkedIn IPO underpricing is a prominent
incident that proves the existence of those IPO Underpricing
theories in real world. IPO underpricing is not limited to Stock
Markets such as US and Australia. IPO Underpricing in Malaysian
Stock Market reminds us that IPO Underpricing occurs in Asia Pacific
region also. Well educated decisions should be taken in IPOs to
avoid losses from such unexpected situations.

Introduction
Going public is a part of making history for a company. Issuing
shares for public opens up a range of opportunities for small and
medium sized companies. It allows them to get public equity to
expand their business. It gives company`s existing investors
opportunity to diversify their investments. It also gives the company
transparency and fulfils disclosure requirements. Issuing shares for
investors through Initial Public Offering (IPO) is the most common
method for the companies to go public.

Short run IPO underpricing in Australian share

market
For the first Question we compiled data of IPO listed on ASX
between January 1 2012 and June 30 2013 using Morningstar
(2015). There were 114 IPO listings within this timeframe, which
were reduced to 71 companies as a sample size.

All companies that did not have issue price were ignored and
removed from the sample. Also four companies were excluded from
the sample since they possessed extremely high initial returns and
skewed the data significantly, representing the false information
about the under-pricing in Australia. These four companies and their
initial returns are:
1.
2.
3.
4.

Zeta Petroleum Plc2600.0%

Red Gum Resources Limited 1845%
Estrella Resources Limited 800%
Cohiba Minerals Limited 206.5%

As three variables following were used:

1. Industry sector
2. Auditor
3. Float Underwriter
Within the industry sector we introduce 4 groups:
1.
2.
3.
4.

Consumer Discretionary and Information Technology

Energy companies
Financial services and Health Care companies
Industrial companies, Materials and Utilities

Using this classification we obtained following data:

Consumer Discretionary and Information Technology companies

showed the highest rate of initial rate of return, which means that
majority of these companies were under-priced while going public.

While Group 3 and Group 4 show very low rate of initial rate of
returns, Energy companies produced negative returns in the first
trading day, meaning that Energy companies were over-priced.
The second grouping variable is Auditors. We believe that pre-listing
audit is crucial for the companys IPO and try to determine whether
the choice of the auditor affects companys strategy to under-price
its shares while going public.
Within this variable we divided companies in 3 groups, those who
were audited by:
1. Australian Auditor
2. International Auditor
3. Auditor from Big 4
From the spread sheet we can see, that companies who were
audited by Australian company on average were slightly underpriced resulting only in 0.46% of initial return.
Companies who undergone the audit by one of the Big 4 on average
were over-priced by 1.34%.
But the highest rate of under-pricing took place for companies that
were audited by overseas auditor, producing 7.25% of initial return
within first trading day.
The last classification represents under-pricing in Australia relative
to whether the company was underwritten or not. The third grouping
variable consists of the following groups:
1. Information missing
2. Not Underwritten
3. Underwritten

IPO underwriter is one of the most important figures in the whole

underwriting process. Usually underwriter is an investment bank,
which specialises in listing company on the stock exchange and
ensures that it meets all legal requirements. Next it contacts
prospectus stock buyer, like mutual funds or insurance companies
and suggests its IPO to them.
Since underwriter plays such a significant role in the IPO it is
important to assess its influence.
15 companies in the sample did not have any information on the
underwriter, thats why they were combined in the separate group
Information missing.
As we can see in the Excel document, the initial rate of return for
companies that were underwritten is larger, than for the companies
that did not use an underwriter in the IPO process.
This could happen due two several factors, or the combination of
those. We believe that either the underwriter recommended the
company to under-price the value of its shares, or the networking
and recommendation of the underwriter to mutual funds and
insurance companies played a positive role for a listed company and
its shares rose above offer price.

Theories of IPO Underpricing

But it is discovered in the researches that, in the first day of going
public, the sold shares get underpriced and share price increases
resulting IPO Underpricing. This IPO underpricing can be seen in

almost every main stock market around the world such as US, UK,
Australia, China, Japan and Singapore.
In the researches done about IPO underpricing, researchers have
come up with many theories. These theories of underpricing can be
categorized in to 4 groups;
Asymmetric Information
Institutional Reasons
Control Consideration
Behavioural Approaches

Asymmetric Information Models Winner`s Curse Model

The most recognized theory of them is Asymmetric Information
which says that IPO underpricing is caused by disparity of
information distribution. Out of Asymmetric Information models, the
most widely seen theory could be Rock`s Winner`s Curse in which
it is assumed that one of the key parties to an IPO transaction
Issuing firm, the Bank and the Investors, knows more information
about the others. Informed investors bid only on well performing IPO
shares while uninformed investors invest generally on all of them.
For uninformed investors, they get all the underperforming shares
they bid for. And in well performing shares, they lose their bids to
the informed investors. So, the uninformed investors earn lower
profits because of the ignorance. And sometimes, these uninformed
investors completely receive the overpriced shares and because of
that, they get negative returns. And when those investors get
negative outcomes, they refuse to bid anymore for IPO s and leave
only the informed investors in the market. But without uninformed
investors, the informed investors are not enough to cover all IPO
offerings. To avoid and minimize this situation IPO s must be
underpriced, so that uninformed investors would not be facing a
great loss.

The incident about LinkedIn`s IPO underpricing can be taken as an

example for winner`s curse model. LinkedIn`s initial offerings`
underpricing was more than 100 percent.

Behavioural Explanations Cascades

According to behavioural theories the underpricing occurs due to
irrational investors bidding up the price of IPO shares beyond the
true value or, the issuers become bias to behaviours and avoid
putting pressure on underwriting banks to take steps to minimize
underpricing. According to Welch, Cascade happens when the
investors form an informed opinion based on their observation on
prices of the earlier investors, and tend to set a price which is lower
than what they believe the true value is, to attract first investors. In
cascade, it gives early investors the market power to underpricing
the IPO.

LinkedIn IPO Underpricing - 2011

The IPO underpricing in LinkedIn debut share release in 2011 is a
major incident that proves the existence of these IPO underpricing
theories. LinkedIn Corp`s shares received more than twice the
offering price in its debut public trading in May 2011. While its initial
release price of a stock was $45 in IPO, the demand increased the
price of a share to $94.25 in the closing price. The raise was more
than 109 percent compared to its issue price. In that situation, the
bankers tried to set a price that slightly increases the stock about 15
percent on the first day of trading. But as it turned out to be, they
have caused underpricing for their shares. LinkedIn which proposed
a value of $3 billion for all its shares was worth $9 billion after the
trade. By 2011, LinkedIn was 37 times worth the 2010 sales.
(Reuters 2011)

IPO Underpricing in US and Australian Share Market

As a dominant market, the underpricing incidents in US stock
markets are subsequently high. According to a study done by
Loughran and Schultz in 2006 and Ritter & Welch in 2002 revealed
that the average initial returns were 18.1 per cent and 18.8 per
cent. (Perera, W (n.d)) In the years of 1990 to 1998, the average IPO
underpricing in US was 14.8 percent. From 1999 to 2000 it was 51.4
percent and 12 percent from 2001 to 2009. In the last five decades,
in the US alone IPO s have underpriced by 16.8 percent in average,
in liquidity, it is more than $ 125 billion in last 20 years. (Solomon
2011).
Not only in US stock market, according to a study conducted by
Wasantha Perera regarding the performance of IPO and its
determinants, says that, the Australian IPO s are underpriced by
25.47 % and 23.11% on adjusted abnormal return. According to
their secondary market analysis the Australian IPO s are overpriced
by 1.55% based on MAR.(Perera, 2014).

Short Term IPO Underpricing in Asia Pacific

Malaysian Stock Market
For the third part of the Assignment we would like to discuss the IPO
under-pricing in Malaysia. Particularly, in this question we analyse
and discuss empirical study by Younesi, Mahdavi and Hashemijoo
(2012)Performance of Malaysian IPOs and Impact of Return
Determinants.
This academic article discusses under-pricing in Kuala Lumpur Stock
Exchange (KLSE) from 2007 until the end of 2010. It also assesses
the impact of factors like size and age of the company, total units
offered, offer price and KLSE index movement on the IPO initial

return. It empirically shows that in this timeframe Malaysian IPOs

experience both decline and unpredicted change in the initial
returns, mostly affected by GFC and post-GFC economic situation.
Methodology
Sample of 66 out of 94 IPOs listed on KLSE during 2007 and 2010
was selected in order to assess the underpricing in Malaysia. They
are well distributed and cover different industry sectors like
Telecommunication, Agriculture, Properties, Consumer Products,
Plantation, and Finance. 28 IPOs were not considered in this study
because of lack information to support the study. (Younesi, Mahdavi
and Hashemijoo 2012).
This study collects data not only on the initial return after first
trading day, but also covers wider timeframe including first week,
month and year after trading.
The initial return of the stocks is calculated using following equation:

IRi , t=

CLP i ,t OFPi ,0
100
OFPi , 0

Where
CLPi , t

= Closing Price of stock i at time t

OFPi , 0 = Offering Price of IPO shares i

Source: Younesi, Mahdavi and Hashemijoo (2012).

The same formula applies to calculating the market return using

Kuala Lumpur Composite Index (KLCI), which represents the overall
situation of Malaysian market. Instead of closing price at time t the
KLCI at time t is used, and instead of offering price the KLCI on the
offering day is used.

In order to calculate the market adjusted initial return the study

subtracts market initial return from the stock initial return.
Analysis of the data
The study presents following data on the mean initial return of IPOs
listed on KLSE from 2007 until the end of 2010.
Table 1. Descriptive statistics of IPO underpricing from 2007 to 2010

Return
Mean Initial Return
St. Dev.
Mean Market Adjusted

2007
11.87%
11.24%

Return

11.87%

Year
2008
2009
7.30%
9.45%
37.15% 18.82%
7.17%

9.66%

2010
0.91%
14.67%
0.94%

Source: Younesi, Mahdavi and Hashemijoo (2012).

Empirical analysis of the data shows that during all four years the
IPOs produced positive initial return in the first day of trading. It is
important to analyse the market adjusted return since it includes
the overall situation of the Malaysian Stock Market. It is worth
mentioning that market returns in this timeframe are close to zero,
resulting in very small difference between mean initial return and
mean market adjusted initial return.
The highest initial returns were observed in 2007 with 11.87% with
the lowest standard deviation among others, 11.24%.
Following 2008 year produced lower results with 7.17% of mean
market adjusted return and highest inconsistency of results,
reaching 37.15% of standard deviation.
Slight increase in market returns with lower rate of deviation from
the mean was produced by IPOs in 2009, reaching 9.66% in initial
returns and 18.82% of standard deviation.

Drastic fall in the initial returns was observed in 2010, having

declined to 0.94% of initial return with standard deviation of
14.67%.
Even though 2010 significantly differs from previous three years, it
can be stated that majority of IPOs listed on KLSE were under-priced
thus yielding high initial returns.
Table 2. Initial returns of IPOs from 2007 to 2010
Initial returns of IPOs from 2007 to
2010
Mean
St. Dev.
Median
Minimum
Maximum
Skewness

7.34%
20.94%
5.99%
-42.63%
98.40%
0.71

Source: Younesi, Mahdavi and Hashemijoo (2012).

Table 2 provides evidence that the sample data is relatively
symmetric, since the median value of 5.99% is close to the mean
7.34% with positive skewness of 0.71.
In this case we observe a drastic fall of the IPO initial returns
compared to similar empirical studies referring to earlier timeframe.
Sapian,

Rahim

and

Yong(2013)researched

the

under-pricing

phenomenon in Malaysia having based their study on 191 IPOs

listed on KLSE from June 2003 until the end of 2008.
Using the same calculation of initial return as this study, Sapian,
Rahim and Yong(2013) came up with 44.42% of initial return with
standard deviation of 46.74%.
As we can see the Global Financial Crisis significantly influenced the
initial return of IPOs and Malaysia can no more produce one of the

highest

rates

of

IPO

underpricing,

which

20

years

ago

reached166.7% (Dawson 1987), 167.4% (Yong 1991) and 114.6%

(Ku Ismail et al.1993)
Table 3. IPO Return Determinants

Factors

Mean
Highest
Lowest
Sig. (2tailed)

Age
7

Size
1,685,000,00
0

Total Units

Offer

KLCI

Offered

Price

Return

159,330,000

1.1

-0.024

5.05

2.16

0.23

-3.28

0.817

0.946

2,480,000,00

37

11,169,747

1
0.64

2,835,000

0
11,753,700

0.814

0.262

Source: Younesi, Mahdavi and Hashemijoo (2012).

Table 3 represents the influence of different factors on the IPO
under-pricing. The Correlation Coefficient test, represented by Pvalues in the last row clearly suggests that since all of the five
determinants are higher than normality =0.05, there is no
relationship between the age, size, total units offered, price, market
return and initial return.
Figure 1. IPOs return comparison from 2007-2010

10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%

Initial Return
Market Adjusted
Return

-20.00%
-25.00%
-30.00%

Source: Younesi, Mahdavi and Hashemijoo (2012).

Figure 1 above proves the previous studies on IPOs (Kenourgios et
al., 2007), which suggest that the investor is unlikely to profit from
investing in the shares of a newly public company and holding it for
a long period of time.
In this bar chart we can see that positive initial return are observed
only in the first day of trading reaching 7.36% of market adjusted
initial return. Just after one week this figure drops to -11.13%, while
continuously falling and reaching -28.06% after one year of trading.
When we analyze this study of IPO underpricing in Malaysia, it is
clear to us that this is yet another incident that proves the existence
of IPO underpricing due to Asymmetric Information and behavioral
theory Cascades. Just like in Australian and US Stock Market, the
investors in Malaysian stock market fell victim to disparity of
information with the global financial crisis which caused IPO to be
underpriced and they could never reach the previous productivity.

Conclusion
This study analyses and discusses the IPO under-pricing in Malaysia
Stock Exchange KLSE and assesses the influence of return

determinants on the initial return.

It empirically shows that KLSE faces drastic fall in the initial return
during the first-day trading falling from 44.42% in 2003-2008 to just
7.34% in 2007-2010.
KLSE was known to produce 100% initial return in the first trading
day back in 1991-2000, but today it can no longer be true.
Post-GFC has significantly influenced the markets while Malaysian
market showed negative market returns.
This study also empirically proves that an investor is unlikely to
profit from funding the IPO and holding his position for a long period
of time, e.g. several months or weeks, since the market adjusted
average initial return of IPOs in one year after listing reached
-28.06%.
Five return determinants like Age, Size, Total Units Offered, Offer
Price and market return were analyzed in order to assess their
influence on the IPO under-pricing. It is proven that none of these
factors played significant role in the stock pricing of newly public
companies.
According to this study we see, IPO Underpricing is a common
occurrence in shae markets around the world. Even though some
people benefit from IPO Underpricing, there is no assurance that it is
always the case. So both the investors and share issuers have to be
well educated about the market before doing any transaction.

Reference
Bachmann, R. 2004, A Theory of IPO Underpricing: Issue, Activity
and Long Run Underperformance, retrieved 27th April 2015
http://bschool.nus.edu/departments/FinanceNAccounting/seminars/P
apers/ralphbachmann.pdf Bakar, N.B.A. 2013, Initial Public Offering (IPO) Underpricing,
Underwriter Reputation and Oversubscription: Evidence from
Shariah- Compliant Companies Listed on the Malaysian Stock
Exchange(MSE), retrieved 25th April 2015
http://ibac-conference.org/ISS%20&%20MLB%202013/Papers/ISS
%202013/B3076..docx.pdf
Ljungqvist .A. 2004 Handbook in Finance: Emperical Corporate Finance Chspter
III.4: IPO Underpricing, retrieved 25th April 2015
https://books.google.com.au/books?
hl=en&lr=&id=l9CTEAZ0IP4C&oi=fnd&pg=PA375&dq=US+ipo+underpricing+&o
ts=mgjvXdK3tn&sig=cDvY6zpnFFIqdixJOea0gPH6mao#v=onepage&q=US%20ipo
%20underpricing&f=false
Perera,K. W. L, Kulendran, N (2014)New Evidence of Short Run
Underpricing in Australia (Pdf), viewed 26th April 2015
http://vuir.vu.edu.au/25676/1/Kotalawala%20Liyanage%20Wasantha
%20Perera.pdf
Reuters- LinkedIn share price more than doubled in NYSE debut 19th
May 4 2011, retrieved 23rd April 2015
http://www.reuters.com/article/2011/05/19/us-linkedin-ipo-risksidUSTRE74H0TL20110519
Solomon. D 2011, Why I.P.O.s get Underpriced , viewed 23rd April
2015
http://dealbook.nytimes.com/2011/05/27/why-i-p-o-s-getunderpriced/?_r=0
Younesi, Mahdavi and Hashemijoo (2012).Performance of Malaysian
IPOs and Impact of Return Determinants. Journal of Business Studies
Quarterly2012, Vol. 4, No. 2, pp. 140-158
Sapian, Rahim and Yong (2013).Ipo Underpricing and Aftermarket
Liquidity: Evidence From Malaysia. International Journal of Business

and Society, Vol. 14 No. 2, 2013, 299 - 318