A Model of the Demand for Investment Banking Advice - Assignment Example

Financial Analyst Customer Insert His/Her Name Customer Insert Grades Course Customer Insert Tutors Name 20, August, 2012. Outline 1. Short-run under-pricing of IPOs in Australia. 2. Holding period return after 2 years. 3. Theories that explain the short-run under-pricing. 4. Facebook IPO failure 5. References Financial Analyst Question 1 As the Chief Financial Analyst of Greentech Company, I had to carry out my study categorically beginning with the economic analysis to survey the economic situation if it is in a boom, recession or in depression. I narrowed it down to industrial analysis to understand how the software firms shares perform in the ASX before analyzing at the company level to forecast the short term and long term financial budget and goals that need to be achieved so as to ensure the company does not fail after issuing the IPO. In order to achieve the objectives stated above, I studied 67 companies that issued their IPO IN ASX from June 1st 2009 to May 31st 2010. Out of the 67 companies, I took a sample of 52 companies which is equivalent to 77.61% of the population. I did this due to incomplete information on 14 of the companies while one was left out due to suspension from the market. Out of this sample selected, the average initial return calculated is -1.17% as shown in the excel worksheet. This negative average return indicates that the IPOs on average were overpriced since their return on the first day of trading were less than the initial offering price.The other variable calculated using the sample include the median - 0.62%, Standard deviation of 32.08, Maxima of 50, Minima of -177, Kurtosis of 16.55 and skewness of -3 indicating that the sample is skewed to the right. On grouping the samples further according to their industry, I found out that mineral companies performed better than renewable resources companies. The mineral companies had an initial average of 4.19% as compared to -1.97% of resources companies. This is a clear indication that most investors estimated to earn more from investing on minerals than renewable resource. This may have been due to the high value that minerals have to the global economy. The mineral specifically mined include gold, coal and petroleum energy, all of which have a high demand worldwide. In addition, to industrial grouping, I further analyzed the companies according to sizes. The analysis of multinational companies showed that their average initial return had a low of -10.47% as compared to small and medium size enterprises that had a high of 2.47%. This may have been due to high taxes imposed on foreign companies and subsidies given to local companies to increase their growth rate. The assumptions I made in carrying out the above analysis includes the assumption that the Morningstar Datanalysis library database had the correct values of IPO and end of first day trading price. Secondly, that the companies celebrated their second anniversary of listing at the ASX. Lastly, that the companies’ shares valuations are correctly stated as these are the values I used in determining the company sizes. In conclusion, I would advise my CEO, Andrew Preston, that our software company has a high probability of having a high initial return should we issue the IPO if we produce software required by mineral companies as they are the market leaders. Question 2 After two years, the holding period return of the companies that issued the IPOs was calculated as shown on the excel file. On average, the holding period return of the companies was 13.62%. This was an improvement when compared to the initial return of -1.17%. This high HPR means that the companies that issued their IPOs from June 2009 to May 2010 had well planned strategic plans that resulted to appreciation of their share prices on average after 2 years of trading in ASX. After further classifying the companies according to their industries, mineral companies had a high HPR of 43.46% as compared to companies that sells renewable resources which had a HPR of -6.1%. In addition to this, small sized companies performed better than large and multinational companies with a high HPR of 42% compared to -3% of big companies. From this analysis, we can therefore conclude that SMEs and mineral companies were the market bulls whereas multinationals and resources companies were market bearers for IPOs that were issued from June 2009 to May 2010 in ASX. The market performance remained the same for the next 2 years with mineral and SME companies’ performance improving while that of multinationals and renewable resources companies stagnated. Question 3 The short run underperformance of IPOs have been studied by several researchers over time and the major conclusion has been that; IPOs show positive significant average first-day return which then decreases after 2 to 3 years of trading (Ibbotson,1975). According to Ibbotson (1975), this underpricing varies in cross sectional analysis study as well as in time series analysis study. Cross sectional variance is whereby different countries IPO perform differently in different stock markets at the same time (Ibbotson, 1975). For example the 2012 Australian IPOs may show an average return of 10% while those of US may have an average high return of 30%. On the other hand, time series analysis shows the variance of a given country’s IPOs after a period of time and the changes that have been effected. A good example of a time series analysis can be the study of Australian IPOs since the year 1990 to 2012. The theories that explain this anomaly of short run underpricing of IPOs have been classified according to the information content that the key players of investment have. The information content across the players can be either asymmetrical or symmetrical. Asymmetrical information occurs when the investor, underwriter or the issuer has more information about the true value of shares than the other. When the issuer is more informed than the investors These arise in situations where the issuer has access to inside information. Generally, the issuer of an IPO is better informed about the true value of the IPO issue than the investors and the underwriters (Welch, 1989). This argument is further explained in the following theory: The theory of signaling; Firm quality High quality issuers voluntarily issue their shares at a lower market price than their true value to discourage low quality issuers from imitating the same (Welch, 1989). Investors, who have limited information concerning the true value subscribe for the shares hoping that the share price will appreciate since the high quality shares are assumed to have been valued more than the issue price. According to Welch (1989) some investors may later conduct a future issue at better terms (Seasoned Equity Offering) SEO or look for favourable market responses with regard to dividend announcement (Allen and Faulhaber, 1989). They desire to make less money in the initial issue and make more in the later SEO issue (Michaely and Shaw, 1994). However the relationship between SEO and initial underpriced IPO issuing does not exist in both investment and statistical analysis and as such this explanation is not relevant and convincing. Guo, Lev and Shi (2006) used a sample of 6010 IPOs issue in the US and concluded that the ratio of expenditure in Research and Development (R&D) expenditures to sales or expected market value of previous year’s IPO fiscal year, are the best measures of asymmetry of information about the issuer’s quality. They found a positive relationship between the firm quality and underpricing. The firm may choose to forgo money lost in an IPO but not in R&D because in the long run, R&D has a positive return which is greater than the loss of underpricing. The trio also introduced the Share Overhang Ratio that illustrates the ratio of shares owned by insiders to the total number of shares issued. They found a positive and statistically significant relationship between underpricing and high quality firm. For a high quality firm, the ratio is high thus indicating that the insiders have high confidence in the firm. When the investor is more informed than the other key players This situation arises when the investor has information about the IPO issue with regard to demand and valuation of the shares. It may be as a result of the following theories: Information revelation theories In this scenario, the investor uses the Book building mechanism to determine the IPO price. The issuer achieves this by hiring an underwriter who in most cases is a bank. The underwriter then collects private information from investors during the pre-selling period about the issuing price that the investors are willing to buy and the demand of shares they may want at that price. After that the issuer will then determine the price from the sample of prices collected by averaging them. If the average price is higher than the estimated price, the investor will raise the issue price and if the price is lower than the estimated price; the investor will lower the price. This use of indications of interest to select the selling price of an IPO reduces the asymmetry of information between an investor and the issuer. However, Ritter and Welch (2002) argued that if the average price estimated is higher than what the issuer was willing to sell at, they must be compensated for revealing useful information. Failure to do so may discourage the investors from buying the shares or issue wrong information to the underwriters during market surveying. To induce investors to buy more shares, the underwriter must provide them with more detailed information with regard to the IPO’s memorandum of association, final accounts and reports. Once the investor has shown willingness to buy, then the underwriter can sell them at an underpriced rate. Under pricing may be a reward for investors for willingness to purchase IPO at a high price level. Research has shown over years that informed investors show more willingness to buy the shares than uninformed investors. The most important thing in this theory is that it concludes that underpricing can be reduced by reducing the asymmetry of information between the investors, underwriters and the issuer. In all cases the underwriters should be treated with due diligence since they are the source of information as they link the issuer to the investors and vice versa. Agency problems with the issuer may create a big problem which in turn may result to big loss to the issuer (Baron 1982; Baron and Holmstom, 1980). The model shows that incase of misunderstanding between the issuer and the underwriter, the underwriter may collude with the investors causing a decline in the share price after the IPO issue (Baron, 1982). Question 4 The failure of Facebook IPO to yield high returns to the investors after it was issued on 19th May 2012 was an incident that most financial analysts looked into and tried to explain the phenomenon that led to this big loss. Several analysts agreed that the reasons stated below were the major contributors of the IPO failure. Banks: Banks subscribed for fewer shares as compared to other previous IPOs such as Google, where they were allotted half of the shares they had subscribed for. In other words, with the Facebook IPO, the banks got exactly what they had subscribed for. This in turn led to low sales at day 1 of trading at the NASDAQ market leading to the failure of the shares. Morgan Stanley: The giant investing company purchased very few shares than what they were expected to buy. This left too many saturated shares in the market that investors could not purchase, as a result it failed to help drive up the price leading to failure in the first day of trading of the shares. The public was more careful: Due to underperformance of previous IPOs; the public was more careful this time not to lose more money. Generally, investors have become more risk averse over time due to past experiences. Economic crisis: People are trapped in the economic crisis due to high mortgage interest rates, high cost of living and other expenses such as collage loans and fees; they had less money to spend in investing in the shares. As such few investors did subscribe for the shares. Facebook is a social site and not a marketing site: No one opens a Facebook account to sell houses and electronics and as such no one will log in to purchase the same items. Since there is minimal marketing that takes place in Facebook, few people were interested to purchase its IPO since it has nothing to do with their business growth. This in turn led to the underperformance of the shares. Investor’s flock: The few investors who subscribed for the IPO did so without enough or competent professional advice. Most of them used the media headlines and story coverage to make investment decision which is actually wrong. Due to their ignorance, they lost their cash in the investment as a result of low turnout of buyers on day one of selling the shares. Facebook delayed to enter the market: When Facebook was first incorporated as a company, it was valued at $50 billion, and this is almost twice its value when it was issued into the market this year May. Investors had less confidence in its future performance thus they subscribed for fewer shares. The General Motor pulls out: A few days to the issue of the IPO, Facebook’s major customer, the GM pulled out due to low sales it was making as compared to the cost of marketing through Facebook. This was a major indicator of failure of the company to the investors, this reduced the subscription. Low earning: Facebook has itself to blame for its failure. The company has experienced a slow growth with a low ROI since 2010 and some financial analysts argued that the share price was far overvalued by approximately 10%. Most investors were more careful to study this and as such they subscribed for fewer shares. Presence of insider information: Information about Facebook’s inside dealing is said to have leaked out through investors such as Morgan Stanley and the agreement they had made with the company CEO, Mark, concerning the IPO. Most analysts in big investment firms such as Wall Street withheld subscription while others blacklisted them due to that material information about the IPO’s true value they had; this resulted in few shares being traded. NASDAQ system failure: The NASDAQ system failed on day one of the selling and due to this, investors doubted the valuing of shares plus the general selling system. Rumor spread around and people minimized their willingness to buy the shares thus leading to the failure of the Facebook IPO. Facebook site’s disorganization: The site is mainly used by politicians for communication and campaign and not many people like politics. Secondly, Facebook does not filter what people update because sometimes you find high school students discussing dirty topics. Thirdly Facebook friends are not really friends as they may be defined because some people add people not because they know them rather because they have many mutual friends. These cause the site to be disorganized and these reasons annoy most people hence they were not interested in buying the shares. The above are some of the reasons that led to the failure of the Facebook IPO. References Allen, F., and Faulhaber, G. 1989. Signalling by Underpricing in the IPO Market”, Journal of Financial Economics, 23, 303-324. Baron, D. 1982. A Model of the Demand for Investment Banking Advice and Distribution Services for New Issues, Journal of Finance, 37: 955-976. Baron, D. and Holmstrom, B. 1980. The Investment Banking Contract For New Issues Under Asymmetric Information: Delegation And The Incentive Problem”, Journal of Finance, 35: pp. 1115-1138. Guo, R., Lev, C. and Shi, C. 2006. Explaining the Short- and Long-Term IPO Anomalies in the US by R&D. The Journal of Business Finance & Accounting, 33: pp. 550-579. Ibbotson, G. 1975. Price Performance of common stock new issues: Journal of financial economics, 2(3): pp. 225-272. Ritter, J. and Welch, I. 2002. A review of IPO activities, pricing and allocations: Journal of Finance. 57, pp. 1795-1828 Michaely, R., and Shaw, W. (1994). The Pricing of Initial Public Offerings: Test of Adverse-Selection and Signalling Theories, Review of Financial Studies, 7, 279-319. Welch, I. 1989. Seasoned Offerings, Imitation Costs and the Underwriting of the IPOs, Journal of Finance, 44:pp. 421-449. Read More