Valuation of unseasoned stocks and the underpricing phenomenon

Abstract

In recent months. Initial Public Offers (IPOs) in Singapore have proven to be an

almost guaranteed source of capital profit because most new issues have been

oversubscribed and investors in these unseasoned stocks have reaped substantial

gains. This project seeks to examine two aspects of IPOs. First. the underpricing

phenomenon of IPOs will be observed through a stock-valuation model on an exante

basis as opposed to an ex-post basis. This is achieved by comparing the forecast

price of the new stock (obtained through the model) against the issue price .

Second, the accuracy of this model in predicting the price of the stock on actual

listing will be examined. The chapter on literature review examines three broad

areas of literature relating to this project. The first section deals with institutional

arrangements and the stock exchange listing requirements. The second section

examines the many theories underlying the underpricing phenomenon of IPOs. The

third looks at the types of models which are being used by stock analysts to value

common stocks. The stock-valuation model used in this project was determined as

follows: Cross-sectional regression analysis was used to determine the weights the

market places on a set of hypothesized determinants of common stock prices. Once

the weights for the determinants were obtained, the relevant financial characteristics

of the firms seeking initial listing (i.e ., the IPOs) were then plugged into this

equation to obtain a forecast price for the unseasoned issue. These forecast prices, which represent the markets valuation of stock. were then compared with the issue

prices and actual listing prices to establish underpricing and the accuracy of the stock

v aluation model respectively . The analysis of results re v ealed two interesting - -

observations . First, all the forecast prices (P1) obtained from the model were higher

than the issue prices (P;) given in the prospectus. This clearly indicates the

existence of underpricing of these IPOs. Second, most of the forecast prices (P1

)

were also higher than the actual closing prices (PJ on the first day of listing. This

can be rationalized as follows : Since the model uses characteristics from seasoned

stocks to price the IPOs. this could explain why the forecast price based on the

model is generally higher than the actual listing price of the IPOs (which are riskier

than seasoned stocks) . Alternatively , we know that the financial characteristics of

companies seeking listing were taken from the IPO prospectus. The figures within

are based on projected figures given by management. Potential investors and stock

analysts who represent the market might discount these forecasted figures, whereas

the stock valuation model used in this project does not. This may thus result in

lower actual prices on the first day of listing as compared to the forecast price

predicted by the stock valuation model.