IPO Under-Pricing Phenomenon - Essay Example

? FINANCE: ASSIGNMENT 2 Table of Contents Part A: Case Study – IPO Under-Pricing 4 Analysis of Short-run IPO under Pricing Phenomenon in Australian Stock Market 4 2. Performance Analysis after IPO 6 3. Theories Explaining Occurrence of Short-run IPO under Pricing in US or Australian Stock Market 6 Part B: Valuation – Dividend Discount Model 9 1. Evaluation of Theoretical Price of Share 9 2. Selection of Companies 9 3. Dividend Discount Model 10 4. Forecasting Growth Rate 10 5. Comparative Earnings Methodology 12 6. Determination of Cost of Equity 13 7. Determination of Theoretical Price of the Selected Company 13 References 15 Appendices 17 Table 1 – Descriptive Statistical Analysis 17 Table 2 – Short-run IPO Performance Analysis in Australian Stock Market 17 Part A: Case Study – IPO Under-Pricing 1. Analysis of Short-run IPO under Pricing Phenomenon in Australian Stock Market The phenomenon of under pricing of Initial Public Offer (IPO) is often considered as an anomaly that is mostly visible in the primary markets throughout the world. But the degree or extent of under pricing varies from country to country and further from sector to sector. Under pricing is defined as the phenomenon when the offer price of a new issue is lower than the price of first trade. It is calculated as difference close price on the date of listing and offer price of issue expressed as percentage of offer price of issue. In the US market, the short run under-pricing is a well known phenomenon but in order to investigate whether this phenomenon exists in the Australian stock markets or not the researcher will have to measure the short-run IPO performance by analysing the returns of IPOs that were listed between chosen time frame and remained listed up to at least 2 year holding period (Rhee, 2002, pp.1-7). By carefully analysing the IPO data of Australian stock markets since 2011, with special reference to the issue price of IPO shares and the last trading close price of the IPO stocks at the end of first day of trading after listing, it can be said that short-run IPO under-pricing phenomenon does exist in Australian stock markets. This is because the issue price of the IPO stocks were significantly underpriced compared to last trading price at the end of first of trading after IPO and listing. A careful analysis of IPO under pricing reveals that when the offer price of new issue is lower than first trading price after listing, then the stock is considered to be under priced. Now, a stock should generally be under priced when there is lack of demand in the market and that the phenomenon should be temporary since under pricing will eventually motivate investors to hold shares which will increase the demand for the shares and thus will consequently increase the price of shares (Bansal and Khanna, 2012, pp.107-108). But, in case of IPO under pricing in US market or Australian stock markets, it is often believed that IPOs are under priced on concerns of uncertainty and liquidity regarding the level of probable trade in the market after listing. Hence, in general any stock which is expected to be less liquid and less predictable will be under priced to greater extent for two primary reasons. The first reason is to compensate the investor for taking risk of holding the stock and secondly increase the liquidity of trading. The general explanation for such phenomenon is that since the issuing entity tends to have more knowledge regarding the stocks and their values compared to investors, the company must under price the stocks to motivate investors to participate in the IPO (Ritter, 1995, pp.1-4). When the firms issue their shares to public through IPO they incur both direct and direct costs. The direct cost includes underwriting fee, registration, legal, and audit fees. The indirect cost includes cost associated with under pricing. In the calculation of under pricing, the first day’s closing price represents investor expectation regarding what they are willing to pay for holding the firm’s shares. When the offer price of issue is lower than the first day’s close price, then the IPO is said to be underpriced which implies that new investors are expected to gain from appreciation of stock value in future. As the existing shareholders of the issuing firm settles for a lower offer price than the actual amount that could be realised from fairly priced IPO, the under pricing also represents transfer of wealth form existing shareholders to new shareholders (Hanley, 1993, pp.231-234). 2. Performance Analysis after IPO In order to analyse the performance of the IPO firms that were listed on ASX from the year 2011, the two year holding period return of the investor has to be determined. The two year holding period return of IPO is calculated using the following formula: Where, P2 = Adjusted close price after 2-years; Pt = Adjusted close price on first day trading; On the basis of above formula, the three best performing IPO stocks as on September 11, 2013 are as follows: i) Dicker Data Limited (DDR) form Technology Hardware & Equipment Industry ii) Exterra Resources Limited (EXC) from Materials Industry iii) Australia New Agribusiness & Chemical Group Ltd (ANB) from Materials Industry The worst performing IPO stock since 2011 after 2-year holding period is MyATM Holdings Limited (MYA) from Software & Services Industry with -98.33% returns after two years. 3. Theories Explaining Occurrence of Short-run IPO under Pricing in US or Australian Stock Market The first ever empirical evidence on under pricing of IPO was revealed from a study by US SEC (Security and Exchange Commission) in the year 1963. Further research on the topic has confirmed that IPOs tend to be underpriced substantially not only in US market but in international markets as well (Loughran and Ritter, 1994, pp.165-199). In the past many researchers have tried to explain the phenomenon of short-run IPO under pricing using theories such as asymmetric information, agency conflicts, Winner’s curse, etc (Huang and Levich, 1998, pp.10-17). Among these theories or propositions, the most plausible explanation for the occurrence of short-run IPO under pricing in US and Australian market can be given using Winner’s curse and agency conflict theories as follows: Winner’s Curse – The essence of this theory is that the theory assumes some investors are more knowledgeable than other general investors, stakeholders of issuing firm and the underwriter. Due to this reason a disparity of information occurs between more knowledgeable investors and potential general investors. The implication of such information disparity is that a better informed investor will bid or invest only for attractively priced IPO shares. This alternately indicates that unattractive shares will not be purchased by informed investor and at the same time the general investors who are uninformed will tend to purchase all shares irrespective of their attractiveness. But the general investors who are uninformed will not be able to absorb all the shares offered in the IPO which is why it becomes necessary to motivate the informed investors to bid and invest for the IPO shares offered even if they think that IPO shares are currently unattractively priced. Hence according to this theory, the short run under pricing as a consequence of lower offer price will motivate informed investors to bid for the offered shares. The theory also appreciates the fact that since under pricing is necessary to motivate informed investors, the pricing should be such that it does not generate negative returns for the uninformed investors, whose participation and capital is required even if valuations are attractive. Thus, according to the winner’s curse theory, under pricing is necessary to increase participation of informed investors (even if valuations are unattractive) and at the same time it is also necessary not to lose the capital of the uninformed investors. The higher pricing might tempt the issuers and investors to panic for a “winner’s curse” and hence the name (Bird and Yeung, 2010, pp.5-6). Agency Conflict – According to this theory, agency problem is expected to arise between the issuer and the underwriter. The reason for this theory to make such assumption is that under pricing represents transfer of wealth from the issuing company to investors. The investors have many options available such as to compete for allocation of under priced stocks or collude with under writer by offering additional payments when shares are under priced. These additional side-payments could induce excess trading resulting from commission paid on adulterated transactions. Again, the investment banker or the underwriter might distribute under priced stocks to the employees of the issuing company in expectation of winning their future business in the consequent follow-on offers. Hence, the underwriters may seek to earn incentive in their own interest for an underpriced IPO. So, according to this theory there will be a clear agency conflict between the underwriter and issuing firm if the former receives commission business for allocating shares at lower price and hence not revealing the true information to potential investors whore are at large uninformed. The theory assumes that the underwriter will take advantage of informational asymmetry over issuing firms to increase their benefits and hence will not fulfil the actual objective of IPO. The concept of agency conflict arises from the fact that generally the underwriters are given discretion for allocation of shares. The theory believes that the main reason for short run under pricing of IPO is that this discretion will not be used by the underwriter in the best of interest of issuing firm and that the underwriter might also price shares much lower than necessary and then allocate the shares to favoured clients for making unofficial gains. Part B: Valuation – Dividend Discount Model 1. Evaluation of Theoretical Price of Share To evaluate the theoretical price of the share of a company that is currently trading on Australian stock market, the Dividend Discount Model may be used. In order to apply DDM to estimate the theoretical value of stock, a suitable stock has to be chosen which has been paying dividend for at least past seven years. The value of common stock is defined as the present value of future dividend stream (income for the shareholders) in perpetuity. The concept is based on the assumption that the corporate entity will have a perpetual life and that it pays regular and predictable dividends to their shareholders. Hence, the first step to calculate the theoretical value of a stock traded in ASX is to select a company which has been paying regular dividends to its shareholders. 2. Selection of Companies In order to get information regarding dividends of the companies listed on ASX and thus select the company which has been paying regular dividends to its shareholders, the official website of ASX.com has to be visited. The official website of ASX stores a complete dividend information database for the listed companies. Having selected the company, the next step will be to download the data of dividend payment history. If the selected company has paid dividends twice in a year (interim and final) then the interim dividends will have to appropriately annualise. Using this past dividend information, a dividend growth rate has to be computed by applying appropriate estimation technique. 3. Dividend Discount Model This method is popularly used to value a company based on certain assumptions and theory. The main concept of the model is that a stock’s worth should be discounted sum of all expected future dividends since dividends are actual earnings available to the owners of the company. The model provides a way of developing unambiguous expected return for the stock as well as the market. Hence, the model helps to evaluate the overall attractiveness of the stock and the market. The model also helps the investor to evaluate the risk factors such as changing inflation and interest rate effects on the stock by offering a superior framework. The mathematical concept of the model is dependent on the following formula: Where, P = Current stock price (Theoretical); g = Constant growth rate (Perpetually), must be less than cost of equity; r = Constant cost of equity of the company (determined by comparative methodology); D1 = Dividend payable next year (forecasted by analysing past trends of dividend distribution) 4. Forecasting Growth Rate As discussed earlier, the Dividend Discount Model assumes that the firm whose theoretical stock price is to be calculated has perpetual life and that the firm pays regular dividends to its shareholders. From the mathematical expression of the model it can be said that in order to estimate the true worth of the stock, a constant dividend growth rate has to be determined that will be further used as to calculate the expected market price of the stock. There are two popular approaches to determine the growth rate – one is by determining annualised growth rate on the basis of past dividend records; and the other is by using the following formula: Constant growth rate = g = r – (D1/P0) Where, r = cost of equity D1 = dividend of next year P0 = current market price of stock In order to determine the growth rate using the first concept, standard spreadsheet functions that are available in MS-Excel may be used. For instance, the FORECAST(x, Known_y’s, Known_x’s) may be used to determine the constant dividends growth rate. In this function, x = required data point that needs to be predicted and it must be numeric (for instance, 7) Known_y’s = it is the dependent array of numeric data (for instance, the firm’s past dividend payouts) Known_x’s = it is the independent array of numeric data and must not be zero On the basis of above discussion, the constant dividend growth rate may be calculated in MS-Excel spreadsheet as follows: ETHANE PIPELINE Date Dividend 1 13-Jul-12 4.15 2 12-Oct-12 4.35 3 15-Jan-13 4.00 4 15-Apr-13 3.50 5 15-Jul-13 3.50 6 15-Oct-13 3.29 D1 3.0631 g (annual) 4.75% 5. Comparative Earnings Methodology The last and most important inputs in the dividend discount model is the determination of cost of equity of the stock whose theoretical value is being estimated. In order to determine the cost of equity, the comparative earnings methodology needs to be applied. Under this technique a sample set has to be collated that constitutes about ten different companies belonging to same or a very closely related sector of the selected company. After collating the sample set the most recent available information for each of these companies has to be obtained. The recent financial data regarding the companies belonging in sample set may be obtained from online website such as Morningstar DatAnalysis, which stores all relevant financial information regarding companies listed on Australian stock market. The same information can also be accessed from Deakin Library by logging in to database using user ID and password. After collection of financial data of the companies, such as published financial statements, Return on Equity (ROE) of each company has to be calculated. The formula to calculate ROE is Net Income per unit Shareholders’ Equity. Then the ROE of each of these companies has to be expressed as percentage equal to net earnings after tax divided by total shareholders’ equity. The arithmetic average of ROEs of these companies calculated thus on the sample set of companies will yield a reasonable estimate of required cost of equity that can be used for calculating theoretical share price of the stock using DDM. 6. Determination of Cost of Equity 7. Determination of Theoretical Price of the Selected Company DIVIDEND DISCOUNT MODEL EPX D1 (Dividend after 1 year) 3.0631 P0 (Current Market Price of Stock/Previous Close Price) 1.84 Required Rate of Return or Cost of Equity (%) 12.51% Constant Growth Rate (%) 4.75%     Theoretical Current Price (using Dividend Discount Model) 39.50 From the above calculation of theoretical price of stock of Ethane Pipeline (EPX) which is listed on Australian stock exchange, it can be said that the current market price (CMP) of EPX is lower than its true worth or theoretical price. The stocks of EPX are undervalued and its prices are expected to rise in future. A general investor may take advantage of this short-run under pricing by buying the stocks of EPX at current market price and then sell it later on future date when the stock prices of EPX appreciates. With the help of such strategy the investor will be earn clean profit. Hence, from the above discussion the importance of DDM in estimating theoretical stock price and consequently decide investment strategy on basis of CMP is apparent. References Bansal, R. and Khanna, A., 2012. IPOs under Pricing and Money “Left on the Table” in Indian Market. [Online]. Available at: http://www.academia.edu/1827996/IPOS_UNDERPRICING_AND_MONEY_LEFT_ON_THE_TABLE_IN_INDIAN_MARKET. [Accessed on September 12, 2013]. Bird, R. and Yeung, D., 2010. Institutional Ownership and IPO Performance: Australian Evidence. [Pdf]. Available at: http://business.uts.edu.au/qfrc/pwc/research/workingpapers/2010/wp6.pdf. [Accessed on September 12, 2013]. Hanley, K. W., 1993. The Under-pricing of Initial Public Offerings and the Partial Adjustment Phenomenon. [Pdf]. Available at: http://deepblue.lib.umich.edu/bitstream/handle/2027.42/30545/0000178.pdf?sequence=1. [Accessed on September 12, 2013]. Huang Q., and Levich, R. M., 1998. Under Pricing of New Equity Offerings by Privatized Firms: An International Test. [Pdf]. Available at: http://people.stern.nyu.edu/rlevich/wp/HL1.pdf. [Accessed on September 12, 2013]. Loughran, T. and Ritter, J. R., 1994. Initial Public Offerings: International Insights. Pacific-Basin Finance Journal. 2. Morning Star, 2013. Morning Star DatAnalysis Premium. [Online]. Available at: http://datanalysis.morningstar.com.au/af/login?xtm-licensee=datpremium. [Accessed on September 12, 2013] Rhee, S. G., 2002. A Review of the New Issue Puzzles. [Pdf]. Available at: http://www2.hawaii.edu/~fima/Working_Papers/iposeo.pdf. [Accessed on September 11, 2013]. Ritter, J. R., 1995. Initial Public Offerings. [Pdf]. Available at: http://bear.warrington.ufl.edu/ritter/rittipo1.pdf. [Accessed on September 12, 2013]. Yahoo Finance, 2013. ETHANEPIPE STAPLED (EPX.AX). [Online]. Available at: http://finance.yahoo.com/q?s=EPX.AX. [Accessed on September 12, 2013]. Zhang, L., 2010. An Empirical Study of Unit IPOs in the UK: Why Do Firms Include Warrants in Initial Public Offerings?. [Pdf]. Available at: http://etheses.bham.ac.uk/1238/1/Zhang10PhD.pdf. [Accessed on September 12, 2013]. Appendices Table 1 – Descriptive Statistical Analysis Issue Price Analysis P2 (Adjusted Close Price after 2 years) P1 (Adjusted Close Market Price) Holding Period return Test Values Test Values Test Values Test Values Mean 1.96 Mean 7.27 Mean 6.35 Mean 188.63 Median 0.20 Median 0.13 Median 0.24 Median -55.00 Mode 0.20 Mode 0.08 Mode 0.23 Mode -85.71 Range 100.00 Range 99.99 Range 80.54 Range 8268.33 Minimum 0.00 Minimum 0.01 Minimum 0.03 Minimum -98.33 Maximum 100.00 Maximum 100.00 Maximum 80.57 Maximum 8170.00 Sum 111.89 Sum 414.18 Sum 361.82 Sum 10752.17 Count 57.00 Count 57.00 Count 57.00 Count 57.00 Table 2 – Short-run IPO Performance Analysis in Australian Stock Market ASX Code Issue Price P2 P1 Holding Period return (%) Initial Return (%) GNG 1 0.79 1.61 -50.93 -21.00% RDG 0.2 0.06 0.25 -76.00 -70.00% RWH 1.83 2.86 1.83 56.28 56.28% AKY 100 100.00 80.57 24.12 0 OZF 0 18.41 14.57 26.36 n/a OZR 0 8.77 14.26 -38.50 n/a QAU 0 15.26 14.94 2.14 n/a RVL 0 30.35 23.84 27.31 n/a SSO 0 11.87 13.95 -14.91 n/a USD 0 9.54 9.88 -3.44 n/a VHY 0 60.59 47.16 28.48 n/a VLC 0 55.78 47.86 16.55 n/a VSO 0 41.87 48.64 -13.92 n/a AGE 0.2 0.08 0.22 -63.64 -60.00% IOG 0.3 0.26 0.31 -16.13 -13.33% TWE 0 5.74 3.15 82.22 n/a AHK 0.2 0.12 0.23 -47.83 -40.00% ANB 0.25 0.28 0.03 833.33 12.00% AQG 0 3.17 8.40 -62.26 n/a AVK 0.2 0.05 0.24 -79.17 -75.00% AWV 0.2 0.04 0.19 -78.95 -80.00% AZQ 0 0.15 0.24 -37.50 n/a AZY 0.2 0.09 0.20 -55.00 -55.00% BCK 0.2 0.05 0.23 -78.26 -75.00% BGG 0.26 0.17 0.24 -29.17 -34.62% BMZ 0.2 0.19 0.24 -20.83 -5.00% BPL 0.2 0.07 0.17 -58.82 -65.00% CDB 0.2 0.03 0.21 -85.71 -85.00% CNS 0.2 0.02 0.19 -89.47 -90.00% CRQ 0.2 0.02 0.25 -92.00 -90.00% CXO 0.2 0.08 0.21 -61.90 -60.00% EPM 0.2 0.01 0.20 -95.00 -95.00% ERD 0.2 0.04 0.23 -82.61 -80.00% EXC 0.2 28.78 0.68 4132.35 14290.00% FRC 0.2 0.08 0.24 -66.67 -60.00% GLY 0.2 0.22 0.26 -15.38 10.00% IVG 0.2 0.07 0.18 -61.11 -65.00% KDR 0.2 0.17 0.22 -22.73 -15.00% LTX 0.2 0.03 0.21 -85.71 -85.00% MBK 0.2 0.03 0.16 -81.25 -85.00% MGV 0.25 0.09 0.23 -60.87 -64.00% NML 0.2 0.12 0.19 -36.84 -40.00% NVG 0.2 0.03 0.19 -84.21 -85.00% NXR 0.2 0.05 0.20 -75.00 -75.00% ORS 0.25 0.14 0.23 -39.13 -44.00% PLH 0.2 0.11 0.35 -68.57 -45.00% PWN 0.2 0.18 0.21 -14.29 -10.00% RGU 0.2 0.01 0.17 -94.12 -95.00% RIE 0.2 0.07 0.19 -63.16 -65.00% SRQ 0 0.05 0.67 -92.54 n/a SWJ 0.2 0.13 0.23 -43.48 -35.00% TLU 0.25 0.08 0.40 -80.00 -68.00% TPR 0.2 0.06 0.19 -68.42 -70.00% WMN 0.2 0.22 0.25 -12.00 10.00% AEB 0.2 0.25 0.32 -21.88 25.00% BNC 1.5 0.30 1.52 -80.26 -80.00% MYA 0.2 0.35 21.00 -98.33 75.00% DDR 0.2 16.54 0.20 8170.00 8170.00% Read More