Academic journal article IUP Journal of Applied Finance

Valuation Errors and the Initial Price Efficiency of the Malaysian IPO Market

Academic journal article IUP Journal of Applied Finance

Valuation Errors and the Initial Price Efficiency of the Malaysian IPO Market

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Studies investigating the pricing of Initial Public Offerings (IPOs) have documented the existence of underpricing (Logue, 1973; and Rock, 1986; and Yong and Isa, 2003). Underpricing refers to the situation where a private company seeking to list its shares on a stock exchange prices its shares to the public at a discount relative to its true value. This allows investors to earn positive abnormal returns if they were to sell their shares once trading commences. The initial abnormal returns are typically measured by taking the difference between the offering price and the opening market price on the first trading day (Yong and Isa, 2003), or closing market price at the end of the first day (Logue, 1973; Ritter, 1984; and Ritter and Welch, 2002), or first week or first month after listing (Cheung and Krinsky, 1994). Although there are a number of explanations as to why IPO shares are underpriced, the most widely accepted one relates to information asymmetry in the IPO market. Due to information gap between the company and the investing public, issuers deliberately price their shares below intrinsic value to induce investors to reveal their demand (Benveniste and Spindt, 1989) or to compensate uninformed investors for the costs of gathering information regarding the company (Rock, 1986). Rock found that the greater the information gap, the greater the extent to which the US IPO shares are underpriced. Other underpricing theories involve a signaling model where issuers underprice their offerings in order to charge a higher price in the subsequent Seasoned Equity Offerings (SEOs). In the signaling models proposed by Grinblatt and Hwang (1989) and Welch (1989), high quality firms may deliberately underprice their IPOs in order to signal their quality and recoup the reduction in IPO proceeds from subsequent equity offerings. An alternative reason for underpricing relates to the moral hazard problem where investment bankers/underwriters underprice new equity issues to minimize their risk of under subscription (Ibbotson, 1975) or to reduce the effort they have to expend in marketing the new issue (Baron, 1982).

The objectives of this study are threefold. First, to determine the degree to which the Malaysian IPO shares are underpriced. If Malaysian IPO shares are indeed underpriced, the study seeks to determine if this can be attributed to changes in market conditions as reflected by movements in the market index (Logue, 1973; Ritter, 1984; and Aggarwal and Rivoli, 1990).

The second objective is to determine if the valuation methods used by the IPO companies to price their offerings contribute to underpricing. Current opinion is divided on whether various share valuation methods can accurately capture the economic value of a company and its growth prospects. At one extreme is the belief that firm value can be determined based on company fundamentals (Ou and Penman, 1989; and Ohlson, 1995). The other view is that the market's assessment and a company's estimate of value are unlikely to be the same due to market inefficiency (Rosenberg et al., 1985). Therefore, an IPO might achieve a low offer price not as a result of a deliberate discount given by the issuers but due to errors induced by the valuation method selected to price the offering (Kim and Ritter, 1999).

Finally, the study seeks to determine how efficient the Malaysian IPO market is. An important implication of market efficiency is that issuers do not need to underprice their shares to compensate investors for the costs of collecting and analyzing information about the issuing firm. This is because information is freely available and all investors have access to the same information (Fama, 1970; and Grossman and Stiglitz, 1980). Thus, it would be difficult for investors to profit from information contained in the prospectus. This line of argument also contradicts the model developed by Rock (1986), who suggests that an information differential exists between investors and an IPO company. …

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