Firms go public when investors are overly exuberant

stock exchange
Why more firms go public as underpricing increases? This has been a puzzle because, if underpricing is a discount to fundamental value, it is difficult to understand why more firms go public when this discount increases, Francisco Santos writes in a new paper. Photo: Wikimedia commons

Firms go public when investors are overly exuberant

Firms prefer to go public in periods when sentiment-driven investors are overly exuberant. In these periods, issuers can take advantage of overvaluations by setting offer prices above fundamental value.

Associate Professor Francisco Santos at the Department of Finance has written the paper «IPO market timing with uncertain aftermarket retail demand», forthcoming in Journal of Corporate Finance (February 2017).

Associate Professor Francisco Santos at the Department of Finance
Associate Professor Francisco Santos at the Department of Finance.

In this paper, he develops a simple model where the decision of going public is driven by investment opportunities and by sentiment investors' overvaluations.

«But, at the time firms decide to go public, the presence of retail investors in the aftermarket is uncertain. Thus, offer prices depend on expected aftermarket demand. The more likely the presence of retail investors in the aftermarket, the higher the offer price.

Good firms, however, have profitable, short-lived, investments opportunities that require immediate finance. Good firms can be lucky and have projects in periods when they can exploit aftermarket overvaluations. But, occasionally, they might have to decide between financing the investment opportunity immediately and postponing the IPO until market conditions have improved. If the NPV of the project is sufficiently high, firms are better off going public even when they do not expect retail demand to drive IPO shares in the aftermarket».

The main contribution of the papers, Santos says, is to provide an explanation for why more firms go public as underpricing increases:

«This has been a puzzle because, if underpricing is a discount to fundamental value, it is difficult to understand why more firms go public when this discount increases. We argue that high underpricing reflects high aftermarket retail demand paying a premium to fundamental value, which creates an incentive for all firms to go public. However, it still remains to understand why investors from time to time become overly exuberant and prone to overvaluations».

Read the paper at Journal of Corporate Finance.

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Sigrid Folkestad Published: 30 December 2016 10:41, updated: 30 December 2016 11:20