Underpricing: Definition, How It Works, and Why It’s Used

What is underpricing?

Underpricing occurs when an initial public offering (IPO) is priced below the price at which the stock ultimately trades in the open market. If a new stock closes above its IPO price on the first trading day, the offering is considered underpriced. The magnitude of underpricing is the difference between the IPO price and the stock’s first-day closing price.

How underpricing works

An IPO is the process by which a private company offers shares to the public to raise capital. Investment banks (underwriters) and company executives set the offering price based on financial analysis, market conditions, and investor interest. When demand exceeds the supply at the IPO price, secondary-market trading often drives the price upward until it reflects perceived market value.

Factors that influence IPO pricing

IPO pricing blends quantitative analysis, market judgment, and comparables:

• Quantitative factors
• Current financials: sales, expenses, earnings, and cash flow.
• Projected earnings and cash flow forecasts.
• Market comparables
• Price-to-earnings (P/E) and other multiples relative to industry peers.
• Market and product considerations
• Size and growth potential of the company’s market.
• Marketability of the stock given current economic and market conditions.
• Underwriter and issuer incentives
• Underwriters may favor slightly lower prices to ensure full subscription and smoother trading.
• Issuers typically want a higher price to maximize capital raised.

Why companies and underwriters underprice IPOs

Underpricing can be deliberate or accidental:

• Deliberate underpricing
• Stimulates demand, creates positive first-day performance, and rewards early investors.
• Reduces the risk of a weak debut that could damage reputation.
• Accidental underpricing
• Underwriters may underestimate investor demand or misread market appetite.

Why underpricing is sometimes preferred

• A modest first-day gain signals market enthusiasm and can generate favorable publicity.
• It reduces the risk of the IPO failing to sell at the offering price.
• Investors who accept the underwriting risk on a new issue may be rewarded with immediate gains.

Risks and trade-offs

• Overpricing is riskier: if a stock closes below its IPO price, the offering is often labeled a failure.
• Underpricing means the company raises less capital than it might have if shares were priced higher—benefiting buyers and possibly underwriters more than the issuer.

Key takeaways

• Underpricing = IPO price < first-day market price; magnitude measured by their difference.
• It can be intentional (to build demand and ensure a successful debut) or unintentional (misjudged demand).
• Pricing an IPO involves financials, comparables, market potential, and strategic choices by underwriters and issuers.
• Underpricing protects against a poor debut but reduces capital raised; overpricing risks a failed IPO.