Unlike many other products and services, pricing of IPOs is very tricky. Our age-old Economic theory says that the best price emerges when demand and supply factors are allowed to freely interact. With all market imperfections, interaction of demand and supply forces determine price in case of most of the products and services. But when it comes to IPO pricing, what is being sold is not a product or service; but a portion of the ownership of an enterprise. Thus, the price depends on the value of the enterprise at large. A fair pricing of IPO is important as the under-pricing deprives capital to the issuer and over-pricing misleads the investor. There are three popular methods of determining the price at which shares are to be offered by a company. They are (a) fixed price; (b) book-building and (c) auction.
Until 1999, IPOs were made through fixed price offers in India. Here, the issuing company, in consultation with its investment banker, decides the price at which the shares are to be issued. The price and the quantity of shares offered are announced and the investors are asked to apply for the number of shares they would like to buy. The inherent problem of this method was, 'how could the issuer decide the price?' In most of the cases, there were huge under-pricing as the issuer, for the fear of the issue failing, was forced to price the shares below its actual value. (I am ignoring huge over-pricing of issues by few promoters with an intention to cheat investors). Our basic theory was compromised here as the demand side factors were not given participation in the process of pricing.
In 1999, Hughes Software became the first company in India to make IPO through the book-building route. Here the issuer, again in consultation with the investment banker, announces a range of price (with a band of 20% or so). The investors are asked to bid for shares with prices within the range. The issue price is decided by considering the demand extracted through the bids. Once the price is determined, all investors who submitted bids for the issue price and above are allotted shares at the issue price. Here the demand side gets participation in the process of pricing in a limited manner as the price range is fixed by the issuer.
The third method, an auction, allows greater interaction between the demand and supply forces. It can be a French Auction (tried by REC and NTPC last year) where the floor price is fixed and the bidders are asked to bid at floor price or above. Or, it can be a Dutch Auction (not prevalent in India, but tried by companies like Google in USA), where the issuer fixes an extremely high price and asks the bidders to bid at lower prices.
Though lot of empirical research has been done on which method of pricing is the most suitable in terms of fair valuation, no conclusive evidence has emerged. Thus pricing of IPOs remains a big puzzle.
Until 1999, IPOs were made through fixed price offers in India. Here, the issuing company, in consultation with its investment banker, decides the price at which the shares are to be issued. The price and the quantity of shares offered are announced and the investors are asked to apply for the number of shares they would like to buy. The inherent problem of this method was, 'how could the issuer decide the price?' In most of the cases, there were huge under-pricing as the issuer, for the fear of the issue failing, was forced to price the shares below its actual value. (I am ignoring huge over-pricing of issues by few promoters with an intention to cheat investors). Our basic theory was compromised here as the demand side factors were not given participation in the process of pricing.
In 1999, Hughes Software became the first company in India to make IPO through the book-building route. Here the issuer, again in consultation with the investment banker, announces a range of price (with a band of 20% or so). The investors are asked to bid for shares with prices within the range. The issue price is decided by considering the demand extracted through the bids. Once the price is determined, all investors who submitted bids for the issue price and above are allotted shares at the issue price. Here the demand side gets participation in the process of pricing in a limited manner as the price range is fixed by the issuer.
The third method, an auction, allows greater interaction between the demand and supply forces. It can be a French Auction (tried by REC and NTPC last year) where the floor price is fixed and the bidders are asked to bid at floor price or above. Or, it can be a Dutch Auction (not prevalent in India, but tried by companies like Google in USA), where the issuer fixes an extremely high price and asks the bidders to bid at lower prices.
Though lot of empirical research has been done on which method of pricing is the most suitable in terms of fair valuation, no conclusive evidence has emerged. Thus pricing of IPOs remains a big puzzle.
Highly informative article. Thank you sir!
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