Investors generally expect companies to make a successful and profitable debut on the stock market with their initial public offering (IPO). However, some stock market launches fall short: The price of shares in Deliveroo’s $2.8 billion IPO in 2021, for example, fell by more than 26 percent when launched on the London Stock Exchange, and the price of Uber shares issued in its $75.46 billion IPO in 2019 dropped, 7.6 percent after their first day of trading on the New York Stock Exchange.
In 2021, around $143 billion worth of shares were issued in U.S. IPOs, but more than 25 percent of those shares showed negative returns on their first day of trading. A quarter is not a small number, considering that an IPO is a time-consuming exercise in valuing the shares and a significant turning point for the company as it transitions from private to public trading.
Pricing an IPO is, however, a difficult endeavor due to an unobservable market price and limited historical data. Therefore, the underwriter typically organizes roadshows to determine the potential market demand. However, to minimize risks, the offer price is, in most cases, set lower than prevailing market expectations. This problem of underpricing is a phenomenon that continues to preoccupy researchers and has been the subject of theoretical reflection and debate since the 1970s.
Accordingly, most of the studies on IPOs focus on underpricing. In a new paper, we look at the other side: IPOs that experience negative returns on the first day of trading. We identify this as a negative event and label this as overpricing, which is the extent of the negative ratio between offer price and first close. Using all common stock IPOs between 2000-2020, we confirm previous evidence of positive average first-day IPO returns of 21.11 percent. In contrast, however, we also note the extent and magnitude of overvaluation, as a substantial 21.27 percent of IPOs record negative first-day returns, making this a common feature of U.S. IPO markets.
We find that this overpricing is pervasive, occurring across industries in 15-30 percent of IPOs and raising significant questions. Do overpriced and underpriced IPOs share characteristics? What are the determinants of negative first-day returns? What can we learn from overpriced IPOs?
To answer these questions, we derive a theoretical framework from the extensive underpricing literature, as we assume that, to some extent, underpricing and overpricing have similar causes. We confirm that the presence of information asymmetries between the different parties involved as well as uncertainty about future cash flows play a role in overpricing. First, we consider specific features of the IPO mechanism to approximate uncertainty before the IPO. Second, following agency-related ideas, we include characteristics of corporate governance in our analysis, as investors are likely to demand signals to eliminate potential agency problems. Third, firm-specific characteristics affect the valuation of an IPO.
We find that more IPOs with negative first-day returns occur at lower offer prices and smaller transaction sizes. We also find that 80 percent of overpriced IPOs occur when the opening price is lower than the set offer price in the latest prospectus. We also find that IPOs with negative first-day returns have fewer over-allotment shares than IPOs with positive first-day returns. Over-allotment shares allow underwriters to stabilize the share price after the IPO if necessary. A surprising 69 percent of shares in our sample were listed on NASDAQ with negative initial returns after their IPO. When considering the underwriter, which plays a key role in the IPO process, it appears that less reputable and prestigious underwriters are more likely to lead the client companies to negative returns on day one. The overpriced IPOs in our sample also have smaller boards and networks and fewer directors of retirement age. In addition to these results, however, it is not surprising that the firms with an overpriced IPO have higher leverage as well as lower profitability.
With this research, we hope to contribute to the debate on IPOs in several ways. First, this study uses an extensive hand-curated data sample of 2,111 IPO firms from 2000 to 2020, of which over 21 percent have negative first-day returns. Second, to the best of our knowledge, this is the first study that explicitly focuses on negative first-day returns and provides empirical evidence. Third, we identify determinants of IPO overpricing and contrast these with what we already know about IPO underpricing. We find that some characteristics’ impact show symmetry while others affect overpricing differently.
This post comes to us from Jacqueline Rossovski, a PhD candidate, at Trinity Business School of Trinity College (Dublin); Brian M. Lucey, a professor at Trinity Business School of Trinity College (Dublin), Ho Chi Minh City University of Economics and Finance, and Jiangxi University of Finance and Economics; and Pia Helbing, an assistant professor at The University of Edinburgh. It is based on their recent working paper, “On the Extent of Negative First-Day IPO Returns,” available here.