IPO Underpricing in Germany - Empirical Analysis of Influencing Variables

MA-Thesis / Master von Justyna Dietrich

Introduction:

Detected on the US market centuries ago, underpricing is the phenomenon of abnormal first-day returns from initial public offerings (IPOs). Without doubt, any US investor would agree, that one day-returns of 11.4% on average are exceptional and a worthwhile investment. Since then many studies have proven that it is a persistent phenomenon and also occurs on markets all over the world.

The most puzzling question for scientists is why companies are leaving this money on the table and don’t set an offering price that reflects the market demand at the offering date. Within that, researchers have also been trying to determine the factors that influence the severity of underpricing. Many different explanations with regard to the existence of underpricing have been derived thus far, with all claiming to be valid even if not exclusively. But despite this effort, research so far has not been able to create common sense. Some even argue that underpricing may not exist at all since most IPOs underperform severely in the long-run which leads some people to the conclusion that IPOs are in fact overpriced.

The main focus of this paper is whether and how the findings of past research, primarily conducted for the US market, apply to the German IPO market. As a result, both investors and issuers shall receive practical implications for their decision-making within the IPO process.

So far, profound underpricing research for the German market has been rather scarce. Most of the available literature concentrates either on dates before 1997 when most offering prices have been determined by using the fixed price mechanism whereas the most recent studies focus on the German stock exchange segment ‘Neuer Markt’ exclusively.

In contrast, this paper aims to give a more recent analysis of underpricing on the German market without distinguishing between different market segments. Additionally, a broad over-view and understanding of IPO underpricing, taking the long-run performance of IPOs into account, will be included.

As a result, this paper is structured as follows: The second section consists of a description of some of the important theoretical aspects that have influence on the price setting of an IPO. It will concentrate on business valuation as it is the basis for setting the price of an IPO. Furthermore, the most common price setting mechanisms shall be explained. Additionally, the special role of the lead underwriter in the IPO process will be outlined as it may also play a role in IPO underpricing. The third section depicts past research results with regard to IPO underpricing and sums up theories for why underpricing exists. Section four focuses on the long-run performance of IPOs and deals especially with the question of whether IPOs are systematically overvalued by investors and why. The empirical analysis is contained in section five. Firstly, the influencing variables of underpricing and the applying theoretical model will be derived. Subsequently follows the presentation and interpretation of the results, as well as the implications for both issuers and investors. Section six summarizes the results from this paper and provides an overall conclusion.

Table of Contents:

Text Sample:

Kapitel 4, Long-Run Performance and Overvaluation of IPOs:

In contrast to the underpricing of IPOs, their long-run performance seems to develop in the opposite direction and thus raises further questions. Loughran and Ritter observe an average annual return for IPOs of 5.1% over a five year period after the IPO. By contrast, the firms they use as a benchmark exhibit a return of 11.8%. Particularly outstanding is the fact, that the worst performance is during the first year and the difference between IPO performance and matching firms is lowest in year five. Ritter additionally finds that IPOs with the highest underpricing perform worst in the long-run.

Researches around the world have conducted similar studies and also come to the conclusion that IPOs underperform in the long-run. Ritter has summarized the international results. The total abnormal return in Germany amounts to -12.1% for three years. Abnormal return means here the return difference between the performance of IPO stocks and their benchmarks that have not issued equity recently. For a range of countries it is between -8% and -46%. Stehle et al. find that the abnormal long-run performance of IPOs and seasoned equity offerings (SEOs) in Germany amounts to -6% in three years for the sample period of 1960-1992.

There is still some discussion in the financial literature about the extent of the poor long-run performance of IPOs due to methodological issues. However, with regard to the context of this paper, this shall not be discussed in more detail. Rather, the fact that IPOs underperform their benchmarks in the long-run is taken as given.

But it leads here to the question, why this long-run underperformance exists. The main arising question is whether and why investors possibly overvalue IPO stocks in the short-run, specifically at the date of the issue and why. Section 4.1 presents some empirical evidence that IPOs are overvalued by investors in the short-run. In section 4.2 possible answers for this initial overvaluation are given.

4.1, Evidence on Initial Investor Overoptimism:

Helwege and Liang find that profit ratios tend to fall from IPO levels. But they also find that only ‘hot’ market IPOs (‘hot’ markets are defined as periods with high IPO volume) underperform with regard to the stock price. Loughran and Ritter also find that firms issuing during years when there is little issuing activity do not underperform much at all, whereas firms selling stock during high-volume periods severely underperform.

These findings may be an indicator that investors overvalue equity issues in certain periods. Purnanandam and Swaminathan indeed find that IPOs are systematically overvalued at the offer date with respect to the fair value. The deviation from fair value for the median firm is about 50% compared to their peers. Their results are also robust to various industry classifications, price multiples and matching-firm selection procedures.

Another outcome of the analysis is that overvalued IPOs experience higher growth in sales in the first year after going public but it declines rapidly and by year five is not appreciably different from that of undervalued IPOs. On the other hand, overvalued IPOs show significantly lower return on assets and profit margins than undervalued companies where the reinvestment rate for both is almost the same. From that they conclude that extreme expectations about the level and persistence of future growth rates may lead to the initial overvaluation.

As described above, there is some evidence that the market is overly optimistic about the prospects of IPOs. In the following section, possible explanations for this initial overvaluation by investors are discussed.