ANALYSIS OF IPO PRICING

Overpriced or underpriced

Shubham kapoor
2014B3A8568G
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Acknowledgement
I would like to thank Dr. Debasis Patnaik for his constant guidance and support for probing me

in the right direction to complete the following Report. I am thankful for his aspiring guidance

and invaluably constructive criticism which made this research possible. I thank my fellow

batchmates for the stimulating discussions and for helping me whenever I needed them, I would also like to

thank the Dept. of Economics for letting me take this project and giving me the opportunity to work on it .
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TABLE OF CONTENTS

Abstract 3

Introduction 4-5

Literature Review 6-9

Objectives 10

Data and sources 11-14

Research methodology 15-16

Analysis of the various factors 17-24

Summary and conclusion 25

References 26-27

Appendix A - Commands used in R 28

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Abstract

In this report we will determine the important factors for the short run under-pricing of the IPOs.

Data is taken for 25 different IPOs issued in the time period 1999-2001. We find that 4 variables

i.e. Age, profit of the company, Listing Delay and PE ratio are negatively related to the initial

first day return of the IPO whereas dummy for companies representing new economies are

positively related to the short run initial return on IPOs. Our study showed results similar to a

study conducted by Sanjay Sehgal in his paper Valuation of IPOs in India-An Empirical study

(2013) where the author has taken the average initial return of the IPOs rather than individual

initial returns in our study.

Keywords: IPO , Underpricing , Initial return

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Introduction
Initial Public offering better known as IPOs are widely used by companies as a medium to go

public. It is better to understand as a first sale of stock to the public by the private company. The

IPO process is generally undertaken by using the help of an underwriting firm to evaluate their

status and assign a value to their IPO, therefore underwriter selection is an important factor while

going public. This entails the main reasons behind the decision of the company to go public. We

shall look into reasons such as the decrease in cost of capital etc. Maksimovi and Pichler (2001)

asserts that IPOs are undertaken to get the first movers advantage and also to increase the

publicity and reputation of the firm. There is a common belief that firms go public to raise equity

and to facilitate the creation of public market where the stakeholders can have a benefit from the

increased liquidity. There is enough evidence to prove that IPOs are generally priced at a value

that is lesser than the value at which the firm believes itself to be at (which is sum of the

discounted future cash flow). In this paper we shall go into the main reasons / motivations behind

pricing an IPO in this manner. The first and foremost factor while considering which underwriter

to choose is their ability to provide the expertise needed to carry out a successful IPO (overall

reputation ,quality of research , industry expertise and Underwriters market making and trading

desk services. As we all know the stock market goes through boom and bust cycles and the IPO

market itself varies from volatile to relatively stable from time to time, therefore the timing of

IPO plays a major role in deciding its performance. Timing is also driven by the attractiveness of

the market. The recent performance of the companies going for IPOs also influence the decision

and timing for going public. Another explanation from Lowery (2001) is that companies go

public when they have reached certain point in the business growth cycle and need external
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equity capital to continue to grow . Earnings Management by firms has been recognized as a

major contributory factor to the short run over performance and long run under performance of

Initial Public Offerings (IPOs) It is generally observed that firms going public resort to earning

management. Indian stock markets are bullish in nature therefore IPOs are overly subscribed and

hence the firms have an incentive to resort to earnings management. The firms with IPOs in 2000

2001 will have greater earnings management than firms who have in 2004-2005 because Lots

of IT companies issued IPOs in 2001-2002 and as there was a positive sentiment among

investors therefore greater propensity of earnings management. ( Ball and Shivkumar (2006) ).

This study comprises of 7 sections , The first one being the introduction . In section 2

there is the review of existing literature on underpricing, Section 3 will mention the objectives of

the study, Section 4 will be about the data and their sources , Section 5 will be about

methodology used in this paper , Section 6 will be a detailed analysis of the various factors listed

in section 5 which affect the underpricing of the IPOs . Concluding remarks will be provided in

section 7.
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Review of Literature

Brau and Faucet ( 2006 ) in their paper Initial Public Offerings: An Analysis of Theory and

Practice surveyed 336 CFOs to compare practice to theory about IPOs. Their sample consisted

of 336 completed surveys composed of 37 withdrawn IPOs, 87 successful IPOs, and 212 firms

that were large enough, but did not attempt to go public. The survey data was assembled and

then companies involved were further distributed into smaller subsets by using the following

conditioning variables Size , founding year , high-tech1 , Underwriter prestige , Venture

capital2 , Ownership decrease , High IPO demand , Hot initial return , Overhang3 .

(Krigman , Shaw and Womack (1991)) tested certain hypothesis on why the firms switch their

underwriters . The authors use two databases for examining the reasons for underwriter

switching: market data containing prices, earnings estimates, and trading patterns from the IPO

until the follow-on offering and survey data containing opinions from corporate executives . if

(1) their IPO lead underwriter left too much money on the table, (2) the IPO placement strategy

was not successful, (3) the trading desk of the IPO underwriter did not maintain an active market

in the IPO companys shares, (4) the IPO underwriters research department did not provide

research coverage in a timely manner, and (5) the IPO company could obtain the services of a

higher reputation underwriter for the following offering. The authors use t-tests, multivariate

1
An indicator variable that equals 1 (100%) if the firm is in a high-technology industry and 0 otherwise
2
An indicator variable that equals 1 (100%) when a VC backs the IPO firm and 0 otherwise .
3
Is defined as the quantity of shares outstanding prior to the issue minus secondary shares offered in the IPO all
divided by total shares offered in the IPO
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Probit analysis, an event-study approach, and a summary analysis of survey responses to find

evidence for or against the above hypotheses

Sandler and hall ( 2014 ) in the paper Corporate governance practices in IPOs Discusses the

governance practices for the largest US IPOs from September 2011 to October 2013 . They

studied Governance features of 46 non controlled4 and in their study companies 70% of

companies has staggered boards5 and More than 90% has plurality voting for uncontested

director elections . They surveyed 100 largest IPOs in deal size and analyzed change in key

governance practices in the three different periods i.e 2007-2008 , 2009-2011 and 2011-2013 .

These key governance practices were 1) Average level of board independence , 2) Fully

independent audit committee , 3) Primary listing of NYSE , 4) Classified boards , 5) Dual or

multiclass common stock , 6) Plurality voting in uncontested board election , 7) Use of

compensation consultant , 8) Independent chairman , 9) Separate chairman CEO .

Kaoru Hosono , Miho Takizawa , Kenji Uchimoto , Keishi Hachisuk (2013) a in their

paper The Funding through Capital Market and Firm Behavior used data set of Japanese

firms from the latter half of the 1990s to 2010 for the analysis of the determinants of the funding

through initial public offerings (IPOs) by non-listed companies, and the funding through

seasoned equity offerings (SEOs) and bond issues by listed companies, as well as the post-

funding firm behavior In the study they have estimated a Probit6 model for the IPO decision and

4
50% of the voting is not held by single individual or group
5
Only a fraction of board members are selected each time.
6
where dependent variable can take only 2 values
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used the Propensity Score Matching7 to select a control group for comparison against IPO

companies to verify whether there is any difference in capital investments ratios and R&D

expenditure ratios before and after IPO. They further divided their Hypothesis into two parts. In

the first part they tested hypothesis for IPO incentives, and hypothesis for SEO incentives. They

tested 1) if the companies have incentives to issue to shares to raise profits for the existing

shareholders . 2) If companies issue shares for funding investments. 3) If listing on the exchange

increase the existing shareholders liquidity . 4) If the company chooses debt ratios that

maximize its value after the tax benefits.5) If the Debt-holders have priority over shareholders in

receiving returns The model which was used by them was :

Alok Panda (2009) in his paper Earnings management in initial public offerings and its

impact on IPO pricing India stated that IPOs generally underpriced so that investors who are allotted

the shares can gain. To further prove what is stated he tested certain hypothesis and did a time series

analysis to arrive at the findings . It was tested that if 1) The firms going public will resort to Earnings

management . 2) If the firms with IPOs in 2000-2001 will have a greater chance of earnings management

than those who have their IPOs in 2004-2005. 3) and if the Firms engaging in the earnings management

7
that attempts to estimate the effect of a treatment, policy, or other intervention by accounting
for the covariates that predict receiving the treatment)
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will have more underpricing on the day of the listing . The author found out that Indian stock markets are

bullish in nature therefore IPOs are overly subscribed and hence the firms have an incentive to resort to

earnings management , also Lots of IT companies issued IPOs in 2001-2002 and as there was a positive

sentiment among investors therefore greater propensity of earnings management .By 2004-2005 sentiment

died an SEBI has tightened the norms.IN 2004-2005 bigger firms approached market with mega issues

exceeding 1000 crores therefore attracting more merchants and reducing earnings management. Better

Regulation , development of capital market and improvement in quality of auditors should bring down

earnings management.
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Objectives

The study aims to achieve the following objectives

1. Firstly it tries to analyze how factors like age , PE ratio , profit and listing delay affect

underpricing of IPOs .

2. Secondly it explores the relationships these factors ( age , PE ratio , profit and listing delay )

have with each other

3. Finally it checks how effectively our model can explain the phenomenon of underpricing .
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Data and their sources

The data for the 25 IPOs about the listing price and the first day closing price is taken from the

Prime database. The first day initial return was calculated and taken as a dependent variable for

representing underpricing. Initial return was calculated by Subtracting issue price from first day

closing price and then dividing it by first day closing price. Also the data for listing date and

Issue opening date was taken from prime database and the listing delay was calculated by

subtracting the two .

The data for P.E ratio and profit of the company was collected from the annual reports of

the companies of the year immediately after their IPO. The age of the company was found out

from the respective websites of the company .

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Table 1 - Showing the initial first day return for the 25 IPOs

Sn no. Company Closing price ISSUE PRICE Initial return

1 ADLABS FILMS LTD. 102.35 120 -0.172447484
2 AJANTA PHARMA LTD. 176.2 225 -0.276958002
3 ANDHRA BANK 8.9 10 -0.123595506
4 BALAJI TELEFILMS LTD. 157 130 0.171974522
5 CADILA HEALTHCARE LTD. 130.15 250 -0.920860546
6 CENTURION BANK LTD. 15.75 10 0.365079365
7 CREATIVE EYE LTD. 64.1 50 0.219968799
8 ELDER PHARMACEUTICALS LTD. 43.55 110 -1.525832377
GEOMETRIC SOFTWARE SOLUTIONS
9 CO.LTD. 869 300 0.654775604
10 GLENMARK PHARMACEUTICALS LTD. 542.35 200 0.631234443
11 IDBI BANK LTD. 14.4 18 -0.25
12 INDIAN OVERSEAS BANK 9.9 10 -0.01010101
13 IT&T LTD. 76.05 81 -0.065088757
14 MASCOT SYSTEMS LTD. 524.5 480 0.084842707
MELSTAR INFORMATION TECHNOLOGIES
15 LTD. 330.1 72 0.781884277
16 MID-DAY MULTIMEDIA LTD. 43.8 70 -0.598173516
17 MRO-TEK LTD. 92.05 95 -0.0320478
18 MUKTA ARTS LTD. 204.55 165 0.193351259
19 PRITISH NANDY COMMUNICATIONS LTD. 165.15 155 0.061459279
20 SYNDICATE BANK 12.7 10 0.212598425
21 TELEVISION EIGHTEEN INDIA LTD. 1688.5 180 0.893396506
22 TIPS INDUSTRIES LTD. 333.55 325 0.025633338
23 VIJAYA BANK 9.5 10 -0.052631579
24 VISESH INFOSYSTEMS LTD. 185.65 50 0.730676003
25 ZENITH INFOTECH LTD. 272.35 110 0.596107949
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Table 2 Listing delay for the 25 IPOs

SL. NO. COMPANY issue opening date LISTING DATE listing delay (days )
1 ADLABS FILMS LTD. 11 December 2000 10 January 2001 30
2 AJANTA PHARMA LTD. 23 March 2000 05 June 2000 74
3 ANDHRA BANK 14 February 2001 04 April 2001 49
22 November
4 BALAJI TELEFILMS LTD. 06 October 2000 2000 47
5 CADILA HEALTHCARE LTD. 09 February 2000 27 April 2000 78
08 December
6 CENTURION BANK LTD. 20 September 1999 1999 79
20 December
7 CREATIVE EYE LTD. 03 November 2000 2000 47
8 ELDER PHARMACEUTICALS LTD. 16 February 2000 28 April 2000 72
9 GEOMETRIC SOFTWARE SOLUTIONS CO.LTD. 28 January 2000 29 March 2000 61
10 GLENMARK PHARMACEUTICALS LTD. 10 December 1999 10 February 2000 62
11 IDBI BANK LTD. 09 February 1999 15 April 1999 65
13 December
12 INDIAN OVERSEAS BANK 25 September 2000 2000 79
13 IT&T LTD. 18 October 2000 01 January 2001 75
14 MASCOT SYSTEMS LTD. 10 April 2000 12 June 2000 63
15 MELSTAR INFORMATION TECHNOLOGIES LTD. 17 January 2000 09 March 2000 52
16 MID-DAY MULTIMEDIA LTD. 12 February 2001 04 April 2001 51
03 November
17 MRO-TEK LTD. 04 September 2000 2000 60
13 September
18 MUKTA ARTS LTD. 10 July 2000 2000 65
11 December
19 PRITISH NANDY COMMUNICATIONS LTD. 04 September 2000 2000 98
27 December
20 SYNDICATE BANK 25 October 1999 1999 63
21 TELEVISION EIGHTEEN INDIA LTD. 16 December 1999 16 February 2000 62
20 November
22 TIPS INDUSTRIES LTD. 05 September 2000 2000 76
23 VIJAYA BANK 27 November 2000 10 January 2001 44
24 VISESH INFOSYSTEMS LTD. 24 November 1999 24 January 2000 61
25 ZENITH INFOTECH LTD. 15 December 1999 14 February 2000 61
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Table 3 PE ratio, Ln(profit) , Dummy for emerging economy , Age

Emerging
Sn no. company Pe ratio Profit (RS) age sector Ln(profit)
1 ADLABS FILMS LTD. 49.7 5,17,00,000 20 1 17.76096834
2 AJANTA PHARMA LTD. 29 3,60,00,000 27 1 17.3990295
3 ANDHRA BANK 7.2 1,16,10,00,000 78 0 20.87254754
4 BALAJI TELEFILMS LTD. 34.25 4,35,00,000 8 1 17.5882715
5 CADILA HEALTHCARE LTD. 71.08 65,60,00,000 48 1 20.30167135
6 CENTURION BANK LTD. 15.6 1,08,00,00,000 8 0 20.80022688
7 CREATIVE EYE LTD. -6.86 4,03,00,000 17 1 17.51186203
8 ELDER PHARMACEUTICALS LTD. 0 16,80,00,000 12 1 18.93947454
GEOMETRIC SOFTWARE SOLUTIONS
9 CO.LTD. 24.02 8,90,00,000 17 1 18.30414693
10 GLENMARK PHARMACEUTICALS LTD. 10.87 52,54,00,000 24 1 20.07967044
11 IDBI BANK LTD. -2.39 7,34,00,00,000 37 0 22.71660468
12 INDIAN OVERSEAS BANK -1.41 5,12,75,77,000 64 0 22.35789906
13 IT&T LTD. 22.7 12,64,00,000 11 0 18.65496204
14 MASCOT SYSTEMS LTD. 18.6 37,50,47,000 8 0 19.74256191
MELSTAR INFORMATION
15 TECHNOLOGIES LTD. 0.11 1,32,00,000 15 1 16.39572739
16 MID-DAY MULTIMEDIA LTD. 0 8,09,60,456 20 1 18.2094714
17 MRO-TEK LTD. 35.1 5,78,00,000 17 1 17.87249933
18 MUKTA ARTS LTD. -64.18 13,80,00,000 23 1 18.74276424
PRITISH NANDY COMMUNICATIONS
19 LTD. -31.5 23,93,00,000 8 1 19.29322855
20 SYNDICATE BANK 21.92 2,34,94,00,000 75 0 21.57742581
21 TELEVISION EIGHTEEN INDIA LTD. 24.3 3,49,00,000 8 1 17.36799739
22 TIPS INDUSTRIES LTD. 39.23 7,19,00,000 26 1 18.09078682
23 VIJAYA BANK 8.75 1,30,90,00,000 70 0 20.99252932
24 VISESH INFOSYSTEMS LTD. 0 2,05,00,000 13 1 16.83593544
25 ZENITH INFOTECH LTD. 0 1,62,61,394 5 1 16.60430439
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Research Methodology

Based on the studies the main variable which will affect the IPO underpricing are given in the

following Exhibit.

Exhibit A Variables taken to explain IPO underpricing

Listing delay ( LD ) The time lag between the closing date of the offer and the issue opening

Date

Age - The number of years from the incorporation of the company to the year

Of their issue

P/E ratio - The price to earning ratio of the company in the year of the issue

Profit - The log value of the Profit of the company in the immediate year

After the issue

Dummy for

Emerging economies - The value of this variable will be 1 for the emerging economies like

biotech,pharma ,IT and entertainment and 0 for the others.

The linear regression for the following variables was done and the initial first day return was

taken as
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Initial return = (Closing price offer price)/Closing price 8

The bivariate regression was done for the five variables and the results are as shown in the table

Table 4 Results of bivariate regression analysis

Variable Coefficient ( t-statistic )

Listing delay ( Ld ) -0.005633 ( -0.726)

Age -0.005254 ( - 1.073)

P/E ratio -0.00344(-.815)

Ln_profit -0.8840 (-1.430)

Dummy ( D1) 0.06422 (0.271)

8
Closing price was taken for the day IPO was issued
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Analysis of the various factors responsible for short run

underpricing

From the results calculated using the bivariate linear regression we will try to analyze the effect

of each one of them on the short run underpricing.

Listing delay

The listing delay is negatively related to the initial underpricing according to our analysis which

should not be the case because as there is delay in the issue, there will be growing uncertainty

about the issue due to which there will be a higher demand for the underpricing of that issue but

because the t value of our analysis is -0.726 hence its not very significant .
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Graph 1 Regression plot of Listing delay vs initial return

PE Ratio

The PE ratio is considered to be an important while measuring the growth of a company. The

negative relation between the PE ratio and the underpricing can be explained by the fact the

higher the growth of the company relative to the industry the lesser there will be demand from

the investors for underpricing.

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Graph 2 Regression plot of PE ratio vs Initial return

Dummy (D1)

The dummy D4 represents the new economies The value of this variable will be 1 for the

emerging economies like biotech, pharma ,IT and entertainment and 0 for the others. It was

found positively related with a t value of 0.271. This indicated that industries with a shorter

history will tend to be more underpriced due to more uncertainty about their future.
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Age

The age was defined as the years between the incorporation of the company and their issue. The

age was found to be negatively related because as the company gets old the investors get more

amount of information about that company and hence they are more certain about investing in it

which reduces the incentive for the companies to underprice their issue.
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Graph 4 Regression plot of Age vs Initial_Return

Profit

The log value of the companys profit was taken because the change in variable is more

multiplicative than additive. The profit was negative related with the underpricing with a t value

of -1.40. The possible reason for that could be that the companies which are making good
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profits their IPOs are demanded much more by the investors due to which there is a lesser need

for the company to underprice their IPO to create demand.

Graph 5 Regression plot of ln(profit) vs Initial return

Table 5 Pairwise Correlation between the factors which influence underpricng

From this matrix we can see which factor will be dependent on the other and if that factor is

positively or negatively related with the other factor. In our data age is positively related to PE

ratio , profit and negatively related to listing delay and the dummy variable which can be

explained by the fact that more will be the age of the company it will have a better growth and

hence a better PE and also a better profit , and also they will not resort to a greater listing delay
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and a negative relation with dummy is suggested that a company with a greater age will not be a

emerging economy .

In the case of PE ratio profit and listing delay are negatively correlated whereas dummy

variable is positively correlated with it, suggesting that for a greater growth perspective company

might have to cut down its profits and also if the growth perspective is high as suggested by PE

ratio then it will not resort to listing delay.

For profit listing delay is positively related whereas dummy variable is negatively related

which shows that the emerging economies will make a lesser amount of profits than the other

companies.

=
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Multivariate analysis

Initial return = + 1 (PE ratio) + 2ln(Profit) + 3(D1)+ 4 Age +

5(Listing delay)

To check how much these variables explain the phenomenon of underpricing, a multivariate

regression was done and the results of the regression are as follows.

It is observed that the R-square value is low (19.35%) which confirms that the short run

underpricing is not predictable. We know from theory that there is uncertainty about the initial

return of the IPO and that is proved by our model because of 19.35% of initial return can be

explained through these variables and hence the initial return of the IPO is very uncertain even

though this can also be because our sample is too small and a bigger sample can be used to

predict average initial return.

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Summary and Conclusion

The above report is an attempt to cover 25 IPOs issued in 1999-2001 in India and found out the

fundamental determinants on the underpricing of the IPOs. The five variables which were chosen

were Age, Ln(profit), Listing delay, Dummy for emerging economies and PE ratio. All the

variables were found to be negatively related with initial return which should not be the case.

Age was negatively related because older the company, more information will be available to the

investors and hence less demand from investors to underprice, Ln(profit) was negatively related

because the firms with higher profit will have a greater demand for their IPOs and have lesser

incentive to underprice. The listing delay should be positively related because more the listing

delay more should be the uncertainty and more underpricing. One possible reason for that can be

the small sample size of 25 IPOs. The negative coefficient of listing delay was not very

significant with a t value of -0.76. The results are similar to the previous literature on this

subject. Also, while checking the relation between each of these factors we found out that age is

positively related to PE ratio and profit and negatively related to the Listing delay and similarly

Profit was negatively related to PE ratio and listing delay. As our model has R-squared value of

of 19.35% it could only explain very few reasons responsible for underpricing and hence the

phenomenon of underpricing is much more uncertain.

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References

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Websites

www.sebi.gov.in

www.moneycontrol.com

www.chittorgarh.com

www.Primedatabase.com

Appendix A

reg = read.csv("D:/project/final1.csv")
summary(reg)
model1 = lm(Initial_return ~ PE, data = reg)
summary(model1)
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with(reg,plot(Initial_return, PE))
abline(model1)
model2 = lm(Initial_return ~ Age, data = reg)
summary(model2)
with(reg,plot(Initial_return, Age))
abline(model2)
model3 = lm(Initial_return ~ D1, data = reg)
summary(model3)
with(reg,plot(Initial_return, D1))
abline(model3)
model4 = lm(Initial_return ~ LD , data = reg)
summary(model4)
with(reg,plot(Initial_return, LD))
abline(model4)
model5 = lm(Initial_return ~ ln_profit , data = reg)
summary(model5)
with(reg,plot(Initial_return, ln_profit))
abline(model5)
model6 = lm(Initial_return ~ PE + ln_profit + D1 + Age + LD ,data = reg)
summary(model6)