Academic journal article International Journal of Business

Issuer-Oriented Underpricing, Share Marketability, and Share Value

Academic journal article International Journal of Business

Issuer-Oriented Underpricing, Share Marketability, and Share Value

Article excerpt

ABSTRACT

Initial public offerings (IPOs) attract academic interest largely because of the price increase between the offering price and subsequent public market-trading price. The shareholder wealth loss ostensibly implied by this "underpricing" is a major reason this phenomenon is considered a financial anomaly. In this paper we argue that the traditional measure of underpricing, as well as those developed by Dawson and Barry are inadequate measures of shareholder wealth change, because they neglect an essential difference between the private and public marketplaces. This difference is the dramatically increased share marketability created when a firm becomes tradable in the public market. To better specify the wealth effects to issuing shareholders, we incorporate a marketability component into Barry's model. The resultant model is consistent with shareholder wealth maximization, the majority of empirical evidence on IPOs, and a growing body of financial theory literature.

JEL: G24, G10

Key Words: Initial Public Offering (IPO); Valuation; Marketability; Liberalization

I. INTRODUCTION

The underpricing of initial public offering (IPO) is shown to be a persistent characteristic of the financial marketplace in Beatty and Ritter (1986) and numerous other articles. Underpricing occurs when the secondary market price exceeds the offering price and is traditionally calculated as the percentage change between these two prices. Prior to Dawson (1987) and Barry (1989) this calculation was perceived to measure the wealth reduction that issuing shareholders suffer whenever their offering is underpriced. This apparent loss in wealth by rational economic agents is a major reason why IPO underpricing is considered a financial anomaly.

In this article, we attempt to change the perspective from which IPO underpricing is viewed. First, we formalize the notion that is often mentioned in the financial press but generally ignored in academic literature--going public is a wealth increasing activity. We argue that the wealth increase results from the increased marketability of firm shares. In the course of our arguments, we draw attention to the fact that the IPO market, like international securities markets and the market for 144 Letter Stock, segments on marketability and that this segmentation has value implications. In the parlance of international finance, when a firm goes public, trading in its share is "liberalized."

For our purposes, we define marketability as the ability of the owner to sell, transfer, or trade the asset at will. Under this definition, the typical domestic owner of publicly-held stock in a U.S. corporation owns a fully marketable asset, while the owner of stock in a privately-held firm owns an asset of highly restricted marketability. We discuss the importance of share marketability in detail in Section IA, but for the moment note that marketability is a far more confined and readily identifiable notion than liquidity. It relates to the legal right to be sold; a right that attaches to the asset itself and does not directly involve such liquidity-related concepts as depth or breadth of the market. Eliminating those types of assets that are contractually convertible to cash (e.g., savings accounts), being marketable is a necessary, but not sufficient, condition for an asset to be liquid.

If it can be established that issuing shareholder wealth increases in an IPO, it becomes plausible to view underpricing as a cost paid by issuing shareholders to increase the marketability of their shares and their wealth. Once we view underpricing as a cost, the more palatable question of inquiry becomes: "Is underpricing a reasonable price to pay for the increase in wealth generated by the public trading of shares?" Underpricing may actually be an insignificant price to pay for the associated wealth increase, but this will never be recognized under the current focus of researchers. …

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