EXAMPLE 6.21 IPO Initial Returns

The decision to go public is clearly one of the most signifcant decisions to be made by a privately owned company. Such a decision is typically driven by the company’s desire to raise capital and expand its operations. The first sale of stock to the public by a private company is referred to as an initial public offering (IPO). One of the important measurables for the IPO is the initial return which is defined as:

The first-day closing price represents what market investors are willing to pay for the company’s shares. If the offer price is lower than the first-day closing price, the IPO is said to be underpriced and money is “left on the table” for the IPO buyers. In light of the fact that existing shareholders ended up having to settle for a lower price than they offered, the money left on the table represents wealth transfer from existing shareholders to the IPO buyers. In terms of the IPO initial return, an under-priced IPO is associated with a positive initial return. Similarly, an overpriced IPO is associated with a negative initial return.

Numerous studies in the finance literature consistently report that IPOs, on average, are underpriced in U.S. and international markets. The underpricing phenomena represents a perplexing puzzle in finance circles because it seems to contradict the assumption of market efficiency. In a study of Chinese markets, researchers gathered data on 948 IPOs and found the mean initial return to be 66.3% and the standard deviation of the returns was found to be 80.6%.¹⁶ A question that might be asked is if the Chinese IPO initial returns are showing a mean return different than 0—that is, neither a tendency toward underpricing nor overpricing. This calls for a test of the hypotheses

We carry out the test twice, first with the usual significance test and then with a 99% confidence interval.