Signalling by underpricing in the IPO market

Researchers have presented evidence that, at certain times in particular industries, initial public offerings (IPOs) of firms' stocks are underpriced. Several models have been developed that offer explanations of these "hot issue" markets; e.g. Baron's model (1982), in which investment bankers have superior information about the firm's prospects, or Rock's model (1986), in which investors are best informed. In the present model, the new firm itself possesses the best information about its own prospects. Good firms use a low IPO price thus signaling to investors that they expect to recoup this loss in their later performance, while bad firms cannot afford such signaling, since they do not expect to perform well. Unlike other studies, this analysis assumes that investors do not have a full prior knowledge of the firm's quality, but rather update their Bayesian priors on the basis of the firm's performance. In the model, firms fall into two types: good firms and bad firms. A firm's type can change through time, depending on its performance. The only basis investors have for their belief about the firm's prospects is the price of its IPO. Over time, they observe either good or bad performance, and thus update their Bayesian prior. The price of a firm will be bid up to the value placed on it by investors, given their revised knowledge of the quality of the firm. The analysis distinguishes between a separating equilibrium, where good firms signal their type to investors with a low IPO, and a pooling equilibrium, where no underpricing occurs, and hence investors cannot tell good and bad firms apart. Pooling is more profitable for good firms if they are likely to remain good, and signaling is more profitable if they are likely to get worse. Empirical evidence confirms that underpricing can signal favorable prospects for the firm, and that it is temporary, industry-specific, and associated with improvements in the profitability of entry. (AT)