Underpricing

Core Description

• Underpricing is the IPO practice of setting the offer price below what the market appears willing to pay once trading starts, often observed as a "first-day pop".
• It can help an IPO clear smoothly and build early liquidity, but it also means the issuer may leave capital on the table.
• Underpricing is usually a short-term price gap: trading, new information, and changing supply (such as lock-ups ending) can quickly move the stock toward an equilibrium value.

Definition and Background

What "Underpricing" means in an IPO

Underpricing refers to an IPO offer price that is set below the issuer's estimated fair market value at the time of pricing. In practical terms, Underpricing is commonly inferred when the first-day closing price is meaningfully higher than the IPO price. That difference suggests investors were willing to pay more than the offer, at least in the initial trading window.

Why it became common: bookbuilding and incentives

Underpricing became widely associated with modern IPOs as bookbuilding expanded in major markets in the late 20th century. In bookbuilding, underwriters gauge demand from institutional investors, then recommend an IPO price that aims to balance execution certainty and aftermarket stability. A conservative IPO price can reduce the risk of a weak debut, lower reputational damage for the syndicate, and encourage participation from large investors who help anchor the order book.

Why it often fades quickly

Even when Underpricing is clear on day one, the effect is often temporary. Once the stock trades freely, the market continuously updates the price based on supply and demand, sector sentiment, and fresh information. In addition, underwriter stabilization activities and limited float on day one can influence early prints, meaning the first-day close is informative, but not a final verdict on intrinsic value.

Calculation Methods and Applications

Headline metric: first-day return

The most common proxy for Underpricing is the IPO's first-day return, using the offer price and a market price after trading begins (often the first-day close).

\[\text{Underpricing}(\%)=\frac{P_1-P_0}{P_0}\times 100\]

• \(P_0\): IPO offer price
• \(P_1\): first-day close (or another chosen first-day price measure)

A positive result indicates Underpricing. A negative result suggests overpricing (the market cleared below the offer).

Choosing \(P_1\): close vs. first trade vs. VWAP

Analysts typically use the first-day close because it is widely available and easy to compare across deals. However, the first trade can reflect the initial clearing level more directly, while first-day VWAP can reduce the effect of late-day volatility. Whichever measure you choose, consistency is crucial when comparing Underpricing across IPOs or time periods.

Adjusting for broad market moves (abnormal first-day return)

Sometimes the entire market jumps or drops on the listing day. To isolate IPO-specific Underpricing, studies often subtract the benchmark's same-day return:

\[\text{Abnormal Return}=\frac{P_1-P_0}{P_0}-R_m\]

• \(R_m\): benchmark return over the same window (for example, a broad equity index)

This helps separate "IPO demand" from "market beta".

"Money left on the table": issuer-side implication

A widely used way to approximate the issuer's forgone proceeds from Underpricing is the first-day price gap multiplied by shares sold in the offering:

\[\text{Money Left on the Table}=(P_1-P_0)\times \text{Shares Sold}\]

This is not a perfect economic measure (fees, greenshoe, and long-run outcomes matter), but it is a clear way to quantify how Underpricing can transfer value from the issuer to allocated investors.

Quick numeric example

Assume an IPO price  \(P_0\): 20 and first-day close \(P_1\)= 26.

• Underpricing \(\approx \frac{26-20}{20}\times 100=30\%\)
  If the benchmark rose 2% on the same day, the abnormal component is roughly 28%, suggesting most of the move is IPO-specific rather than market-wide.

Comparison, Advantages, and Common Misconceptions

Pros and cons of Underpricing (who gains, who pays)

Underpricing vs. related terms

Underpricing is often confused with outcomes or broader valuation concepts. This table keeps the language precise:

Common misconceptions (and the practical fix)

"Underpricing means the company lost cash on day one."

IPO proceeds are fixed at the offer price. The first-day gain accrues to investors who received allocations, not to the issuer. Underpricing can still be costly for the issuer, but it is better described as foregone proceeds ("money left on the table"), not cash disappearing from the balance sheet.

"Any first-day rise proves the IPO was mispriced."

A first-day pop can reflect scarcity (small float), sentiment, index-related flows, or conservative pricing under uncertainty. Underpricing is a useful signal of excess demand, but it is not a clean proof that intrinsic value is higher.

"Underpricing is always good for investors."

Only investors who get allocated at \(P_0\) capture the classic Underpricing payoff. Many participants buy after the pop, when the gap is already reflected in price. Underpricing can therefore benefit a narrow set of buyers while increasing risk for late entrants.

"Underpricing is permanent."

Underpricing is usually brief. As new information arrives and trading normalizes, prices can mean-revert or re-rate depending on fundamentals. Treat Underpricing as a day-one pricing gap, not a long-term guarantee.

"Underwriters alone decide Underpricing."

IPO pricing is a negotiation among issuer, underwriters, and demand discovered in bookbuilding. Underpricing reflects incentives, risk management, and market conditions, not a single actor's unilateral decision.

Practical Guide

How investors can use Underpricing without chasing hype

Underpricing can be used as a diagnostic tool: it indicates that demand at listing exceeded the offer-level supply. It does not indicate whether the post-pop price is attractive. A practical approach is to separate (1) early price mechanics and (2) fundamentals.

A simple workflow (education-only)

• Step 1: Confirm the Underpricing signal. Compare the IPO price to the first-day close and compute the first-day return.
• Step 2: Check float and supply dynamics. Low float can amplify Underpricing and volatility. Lock-up expiries can add supply later.
• Step 3: Compare valuation to peers. Use consistent, plain metrics (revenue multiple, gross margin profile, profitability trajectory) rather than relying on the IPO price anchor.
• Step 4: Plan execution and risk limits. IPO allocations can be small. Secondary-market spreads and volatility can be large. If participating via Longbridge ( 长桥证券 ), treat allocation uncertainty and fast price moves as baseline conditions, not exceptions.

Case study: Airbnb (2020) and the "money left on the table" idea

Airbnb priced its IPO at \$68 per share and closed the first day at \$144.71 (Nasdaq official historical data). Using the headline formula:

• Underpricing \(\approx \frac{144.71-68}{68}\times 100 \approx 113\%\)

This does not mean the company "lost" \$76.71 per share in cash. It means the market-clearing price after trading began was far above the IPO price, implying the deal could likely have raised more proceeds at a higher offer, if demand was reliably there at pricing time.

What this illustrates for learning:

• Underpricing can be extremely large in high-attention IPOs.
• Early trading can reflect scarcity and sentiment as much as fundamentals.
• The key takeaway is analytical: Underpricing highlights a gap between negotiated offer pricing and immediate public-market clearing, not a guaranteed opportunity for those buying after listing.

A checklist to avoid common Underpricing traps

All examples above are for education and market-structure understanding, not investment recommendations.

Resources for Learning and Improvement

High-quality primary references

• Regulators and exchanges: SEC and FINRA investor education pages, plus major exchange rulebooks and IPO guides (e.g., NYSE, Nasdaq, LSE) for how offerings, stabilization, and disclosures work.
• Official filings: Prospectuses and amendments via SEC EDGAR for offer terms, risk factors, use of proceeds, and lock-up details.

Market data and deal analytics

• Market data platforms: Bloomberg, Refinitiv, and S&P Capital IQ for first-day returns, float, ownership, and peer comparisons.
• IPO and deal databases: Dealogic and similar services for consistent samples when analyzing Underpricing across time.

Research and textbooks

• Academic journals and working papers: Journal of Finance, Review of Financial Studies, and NBER working papers for foundational Underpricing models (information asymmetry, winner's curse, bookbuilding incentives).
• Practitioner education: University corporate finance course notes and widely cited IPO researchers' public materials (commonly used in IPO Underpricing literature).

How to evaluate credibility quickly

FAQs

What is Underpricing in an IPO, in plain English?

Underpricing means the IPO price was set lower than what buyers quickly proved willing to pay once the stock started trading. It is commonly seen when the first-day close is above the offer.

How do I calculate Underpricing?

A standard approach uses first-day return: \(\frac{P_1-P_0}{P_0}\times 100\). Here \(P_0\) is the IPO offer price and \(P_1\) is the first-day close (or another consistent first-day measure).

Is Underpricing always intentional?

Not always. Underpricing can be deliberate to reduce execution risk, but it can also reflect uncertainty, conservative assumptions, or a sudden shift in demand between pricing and the first trading session.

Who benefits most from Underpricing?

Investors who receive IPO allocations at the offer price tend to benefit most. The issuer may face the trade-off of raising less capital than it might have if the offer price were higher.

Does a big first-day pop mean the stock is undervalued?

Not necessarily. Underpricing is about the gap between offer price and early trading. Undervaluation is a broader claim about intrinsic value, which requires fundamental analysis and may not be resolved on day one.

How long does Underpricing last?

Often not long. As supply and demand balance out and new information is digested, prices can move toward an equilibrium level. The initial Underpricing signal can fade quickly.

Can retail investors reliably profit from Underpricing?

Only if they receive shares at the IPO price, which is not guaranteed and can be limited in high-demand deals. Buying after listing may mean the Underpricing has already been reflected in the market price. Using Longbridge ( 长桥证券 ) may provide access routes, but it does not remove allocation limits or volatility risk. Investing in IPOs involves market risk, including the risk of price declines after listing.

What's the most common mistake when discussing Underpricing?

Confusing the first-day pop with "free money". Underpricing is a market-structure outcome and a pricing decision. It can reveal demand intensity, but it does not ensure favorable long-term returns.

Conclusion

Underpricing is best understood as a deliberate (or sometimes unavoidable) gap between an IPO's offer price and the market's initial clearing price once trading begins. It can support deal success and early liquidity, but it can also represent meaningful foregone proceeds for the issuer and heightened volatility for investors who buy after the pop. Use Underpricing as a signal, then validate it with float analysis, lock-up awareness, and valuation discipline rather than treating the IPO price as an anchor or the first day as a final verdict.