Under Pricing And After Market Performance- A Study On Indian Initial Public Offering

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The Dissertation entitled Under Pricing and After Market Performance- a Study on Indian Initial Public Offering is the outcome of my sole effort with the advice and help of many. First I am grateful to the Almighty for the endless help and enthusiasm extended to me for completing the work on time. I am also thankful to my Professor (Name here) for his/her valuable supervision and advice for producing a quality work. Next, I am indebted to each and every friend of mine for the help and enthusiasm they extended to me for completing the work without much difficulty.

I am also grateful to University (Name of the university) for the help and learning environment extended to me for studying and preparing a dissertation on finance. Finally, I would like to thank my parents for the warm influence and love which ha been a source of inspiration for me for the successful completion of the work.

Abstract

The work entitled under pricing and after market performance- A study on Indian Initial Public Offering is an attempt to examine the important determinants of under pricing and analyse the behaviour of initial public offering return and after market performance in Indian context. The researcher takes a sample of 20 Indian Initial Public Offering listed on both Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The samples are selected on a certain conditions to ensure the authenticity of the data collected and the generalisations arrived at after the completion of the work. Many research studies have been undertaken in the field of market under pricing and long rum market performance. Many of them came out with results that under pricing are a common phenomenon in the stock market IPO and the long term performance of common stock is exactly in opposition to what is seen during the initial period of the stock in the market. The researcher demonstrates that under pricing is prevalent in Indian IPO market also with the support of the present data that shows Out of 40 listings by IPOs (20 IPOs) in both BSE and NSE, 29 IPOs result in positive return which accounts for 72.5 percent of total IPOs in BSE and NSE. In other word around 73 percent of IPOs are under priced in Indian market. The research also claims that the remaining 27.5 percent of total IPOs results in negative initial return or are under priced. The researcher concludes his work by accepting the hypotheses that IPOs in Indian market exhibit under pricing behaviour and long-run performance of IPOs in Indian market is negative.

CHAPTER 1

INTRODUCTION

1.1 Executive Summary

Initial Public Offering (IPO) has been a prominent source of corporate financing for

many years. IPO pricing is a much debated and yet unresolved topic in financial literature. Many rules and regulations have been developed by market regulators in tackling the issue. However, all efforts turned futile as the issue is becoming more and more complex as time passes. “The empirical evidence on the pricing and performance of IPOs provides a puzzle to those who otherwise believe in efficient financial markets. The puzzle of IPOs pricing both in the short- and long-runs has become a leading example of pervasive market inefficiency” (Ibbotson, et al1994). The three anomalies that have been controversial in stock market are under pricing, the hot issue market, and the long-run underperformance. Under pricing is one of the anomalies of stock market. The under pricing of initial public offer is interpreted in another way, i.e., high initial return. Under pricing is the state where the actual price of the stock is less than its intrinsic value. Under priced situation is a short run phenomenon as the market price will come close to intrinsic price when the demand for under priced securities goes up. When an IPO is under priced, the initial market return will be high. Long run performance of the stocks is the second most important controversial issues in stock market. Investors put their hard earned money in stocks with the expectation of getting a desired return. But, stock market seldom meets their expectations. The present research study is a detailed examination of the under pricing and long term performance of 20 IPOs in Indian market listed on Bombay Stock Exchange (BSE) or

National Stock Exchange (NSE)or both. The paper attempts to investigate both under pricing and under performance of IPOs in the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) for a period of one year. The paper has five chapters altogether, which are arranged logically to fulfill the qualities of a research paper. The first chapter- Introduction describes all the fundamental aspects of the research study. It portrays the background of undertaking the research, the research questions to be investigated, objectives to be attained, hypothesis to be proved or disproved, methodology to be applied, the probable analytical tools to be used and the limitations of the present study. The second chapter entitled ‘Initial Public Offering- A theoretical Framework’ is an attempt to describe all the issues of Initial Public Offering in the Indian context. It tries to cover the aspects that range from fundamentals to intricacies of IPO. It is meant to give the reader thorough insights on Initial Public Offering and the related issues dealt in the research study. The third chapter entitled ‘Literature Review’ deals with the writings of the research topic which have been undertaken across the world. It includes books, articles, and research papers. The review is presented in two sections. Section I exhibits those related to under pricing of IPOs and Section II includes writings connected with long term performance of IPOs. The review includes national and international studies and journal articles. In the fourth chapter a detailed analysis of the research study is undertaken. This chapter deals with measures that have been used to investigate into the intricacies of under pricing IPOs and its long term performance of IPOs in Indian market. The last chapter is meant to summarize the research findings that have been explored by the researcher, the recommendations and suggestions to solve the research problem based on the hypotheses tested and conclusion.

1.2 Background of the Study

Empirical studies across the capital markets in many countries documented different

behaviour of short and long-run behaviour of return of Initial Public Offering (IPO). The pricing dilemma has been overcome with the innovation of book building process by investors are given the opportunity to decide the price at which they are ready to purchase the securities. However, the uncertainty as to the initial return and long term performance of IPOs still remain a puzzle for the entire finance professionals and the investing community. The studies on the short and long run performance of stocks undertaken so far reveal that IPOs are under priced (high initial

return) in the short run, whereas in the long run the evidence is that of underperformance

(negative return). Many factors have been attributable to this phenomenon of IPO market. The important factors associated with under pricing that are found in the general market conditions include nature of the industry and activity based industry classification, reputation of lead managers, the informed institutional and uninformed individual investors, and so on. Based on the empirical results some theoretical models have been developed over the years. In one of the Korean studies, Guray Kucukkocaoglu has explained four different theories in this regard. These are (i) “information asymmetry between the investors, the issuing firm and the underwriter, these models assume that one of these parties knows more than the others, (ii) institutional reasons, institutional theories focus on three features of the marketplace: litigation, banks’ price stabilizing activities once trading starts, and taxes, (iii) control considerations, control theories argue that under pricing helps shape the shareholder base so as to reduce intervention by outside investors once the company is public, (iv) behavioral approaches, behavioral theories assume either the presence of ‘irrational’ investors who bid up the price of IPO shares beyond true value, or that issuers suffer from behavioral biases causing them to put insufficient pressure on the underwriting banks to have under pricing reduced” (Kucukkocaoglu). These theoretical models

come out with almost identical results that IPOs are undervalues and initial investors are getting high return on their informed or uninformed investment. At this juncture, a study is carried out in the Indian IPO market to empirically prove or disprove some of the IPO puzzles that have been discovered in many IPO markets all over the world. The study aims at describing and analysing the IPO phenomenon in general and particularly in Indian market.

1.3 Research Problem

Initial Public Offering under pricing and long run poor performance of common stock has been an unresolved puzzle in the financial literature for many years. Researchers and practitioners have attempted many times to explore a theoretical base to explain the behaviour of IPO market in the history of Indian capital market. But, after each study the findings seem to be totally different from that of the previous ones. No single study could explore all the issues connected with IPOs in Indian market. IPOs are said to be under priced when they earn large initial return. Initial returns are earned by those who purchase stocks from the IPO market rather than from those who buy from the after market. Therefore, the present study is an attempt to investigate into the under pricing phenomenon and the long-run performance of IPOs in Indian capital market during the period beginning from August 1st 2007 to August 11th 2008. The study takes only those IPOs which have been priced using book building procedure and listed on Bombay Stock Exchange or National Stock Exchange or both.

1.4 Objectives of the Study

Any research has some objectives, which act as the direction for the smooth flow of

research processes. It helps the researcher to make sure that whatever he does in the process of research is relevant or not. The present study is carried out to explore the puzzle of IPO

performance in the short run as well as in the long run. It is common knowledge that IPOs are under priced and in the long run IPOs performance is unsatisfactory and investors are given negative returns. In this context, the study has the following specific objectives:

1. To identify and describe the factors affecting the IPO under pricing phenomenon in Indian market,

2. To examine the short- and long-run performance of selected IPO firms in the market,

3. To measure the under pricing of selected IPOs in Indian market, and

4. To measure the long term performance of selected IPOs in Indian market

1.5 Hypotheses

A research to be complete must have a hypothesis or group of hypotheses to prove or disprove something. A hypothesis is an assumption about the probable outcome(s) of research, which is (are) yet to be tested. The research problem, objectives and hypothesis are interrelated and expressed in different ways so as to extend the scope of the study. The probable outcome is the solution to the research problem, which demanded the very need for a research. The present study is also undertaken with certain hypotheses. They are stated as below:

 IPOs in Indian market exhibit under pricing behaviour

 Long-run performance of IPOs in Indian market is negative

The above hypotheses are called null hypotheses by statisticians and in case the above statements turn to be untrue, its alternative hypotheses are formed and accepted. The alternative hypotheses are the exact opposite of the null hypothesis and need not be expressed. Initially they are implied and in case the null hypotheses are not valid after the research, the alternative hypotheses are accepted.

1.6 Research Methodology

Every study has a unique methodology to follow to attain the research objectives.

Research methodology involves the selection of all the methods and tools for the successful

completion of a study. It involves data collection, selection of data sources and its instruments, data analysis and analytical tools and the like. The overall design of the present study is quantitative and it solely relies on secondary data. This is fundamentally a survey study where the data are collected using one of the survey methods. The data are collected from the websites of companies which have been selected as samples for the study. No primary data needs to be used as the study is basically historical in nature. The data collected are underwent a detailed analysis for producing the results and findings, which become the basis to conclude whether the hypotheses set are to be accepted or rejected. The various aspects of present research methodology are discussed below:

1.6.1 Research Design

The present research is both descriptive and diagnostic in nature. A descriptive research is one which is concerned with describing the characteristics of certain phenomenon and diagnostic research is one which is meant to analyse the association of two or variables or to study how many times (frequency) a certain event occurs. The study revolves around the IPOs in Indian market over a period of one year to examine the under pricing and long term performance of common stocks. It takes in to account only those IPOs which have been prices as per book building procedure. Therefore, fixed priced IPOs have been kept away from the study. The study is both descriptive and diagnostic in the sense that both research designs share some common

characteristics such as setting the objectives and hypothesis and furthermore, the study involves the description of the IPO short and long run performance and the analysis of the association of certain variables in the study. The various components of the research design such as data collection and analysis are described below:

1.6.2 Sampling Design

The Initial Public Offerings (IPOs) during the last one year commencing from August 1st 2007 to August 11th 2008 constitute the population for the study. The population of the study is finite as the number of IPOs listed on the stock exchange is available and countable. Altogether, during the period of study 87 IPOs have been undertaken in BSE or NSE or both. The sampling frame has been taken from the website ‘Chittorgarh.com’ that provides latest IPO information. “This is the website to check IPO allotment status online, IPO listing information, IPO News, IPO Reviews, IPO Grey Market Premium and IPO discussion forum” (Chittorgarh). Of the 87 IPOs listed on BSE or NSE or both, 11 IPOs have been issued on fixed price basis. Therefore,

the present study takes only 77 IPOs which have been priced using book building process. Out of the population of 77 IPOs, 20 IPOs are taken as samples for the study. Therefore, 20 IPOs which accounts for around 26 percentage of the total population constitute the sample size.

1.6.3 Sampling Procedure

From the population of the study, a certain number of samples are selected using the

probability sampling procedure. In a probability sampling procedure, all the units of population have equal chance of being included so that the chance of personal bias of the researcher is minimal. In the probability sampling survey, simple random method is the one used to form the sample size. The simple random method ultimately uses lottery method by which the IPOs are

selected to form the sample size. Of the total IPOs, the sample should have the following parameters:

 The firm should have been listed on BSE or NSE or both

 The IPOs must have been undertaken during the period of study, i.e. August 1st 2007 to August 11th 2008

 The IPOs must have been priced using Book building procedure

1.6.4 Data and Data Collection

As mentioned already, the study solely relies on secondary data. Data on various IPOs carried out during the period commencing from August 1st 2007 to August 11th 2008 are collected constitute the sole data for the study. The data on IPOs are collected from the website ‘Chittorgarh.com’ and the information on the price and performances of each IPO are then collected from the websites of each IPO firms.

1.6.5 Data Editing and Coding

The data collected from various sources such as companies and websites are then

tabulated for the purpose of editing and coding. Editing is performed to avoid any errors and mistakes committed intentionally or unintentionally during the process of data collection and tabulation. The edited data are then coded using the MICRO Soft Excel Spread Sheet program.

1.6.6 A Brief Account of Data Analysis

The coded data are then used for analysis to derive research findings. The study mainly revolves around the method and accuracy of analysis as it is basically a quantitative one. Therefore, analysis assumes great importance in the present research. The two important areas

where analysis is demanded in the present study are measurement of under pricing and the long term performance of IPOs. The following measures are used to analyse the data.

Analytical Tool for Measuring Under pricing of IPO

“Under pricing of an IPO is measured as the return on the first day of trading (relative to the offering price). It is computed as the difference between the closing price on the first day of trading and the offer price, divided by the offer price”(Singh). The under pricing of IPOs can be measured with the help of the following model:

P−P

IR

i

1

=

P

0

0

Where,

IR

i

= subscribers’annualreturn

1

0

P =ClosingPriceonthefirstdayof trading P = Offerprice

(Source: Singh)

Analytical Tool for Measuring Long term performance of IPO

“To examine the long-run performance of Indian IPOs, Buy-and-Hold Abnormal Returns (BHAR) and Cumulative Abnormal Returns (CARs) for 120 months of secondary market returns have been calculated” (Singh)

. The long run performance of IPOs can be measured with the help of the following:

T T

BHAR iT =

∏ (1+ R )it

t =1

−∏ (1+ R mt )

t =1

Where,

BHARiT = the buy-and-hold abnormal return for firm i during holding period T,

Rit = the raw return for firm i in month t, and

Rmt is the return of the BSE sensex or Nifty used as the benchmark return.

(Source: Singh)

1.7 Limitations of the Study

The study is basically a sample survey research. Therefore, sampling errors are the first and foremost problem of the study. However, maximum effort has been made by the researcher to minimise the sampling errors by properly selecting the sample method and sample units. Another limitation of the study is that it relies heavily on secondary data and data are collected from a web site, the authenticity of which is uncertain. However, every effort is put by the researcher to make cross check between various connected data.

1.8 Conclusion

In this chapter, the researcher tries to describe the various fundamentals of the present research. Therefore, an outside reader can get an insight on the various aspects of research such as research methodology, sample and sampling procedure, data and data collection and so on. The next chapter entitled Initial Public Offering- A Theoretical Framework is an attempt to narrate all the theories of Initial Public Offering so as to give an in depth knowledge of IPOs in general and especially in the context of Indian Capital market.

CHAPTER II

Initial Public Offering – A Theoretical Frame work

2.1 Introduction

It is known to everybody that newly floated public companies raise funds either by

issuing debt security or equity (stocks). Starting with debt securities is impossible for a company in an efficient capital market. Issuing stocks is the next option for raising huge funds from the market, which is popularly known as Initial Public Offering (IPO). Therefore, IPO is the first sale of stock by a company to the public. In other words, IPO is the first offer of stock or ordinary shares by a public company to the public at large. It is the selling of securities to the public in the primary market. An IPO occurs “when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities for the first time to the public is known as IPO. This paves the way for listing and trading of the issuer’s securities. The sale of securities can be either through book-building or normal public issue” (Stock Market- Articles for Beginners). The market in which companies offer stocks is known as Primary Market. Primary market is one where only first hand securities are bought and sold. As opposed to primary market, secondary market deals with securities which have been traded in the primary market and listed in a stock exchange. In India, IPOs are regulated by Securities and Exchange Board of India (SEBI), which is acknowledged as the whole market regulator. This chapter discusses the basics of Initial Public Offering and its issues and challenges in general. Moreover, an effort is made to examine the IPO system in India and some successful stories of IPO in the country.

2.2 Rationale for Going Public

Companies undertake IPOs for a number of reasons some of which include the following:

 To finance the new investment needs of the company  To broaden the shareholder base of the company

 To improve the liquidity of market where securities are to be traded

 To attract the media and capture the attention of general public

 To attain better rating by rating agencies that will be of immense help for debt issue  To help for the issue of employee stock ownership plans.2.3 Initial Public Offering- How Does It Work

Going public is not a simple task as many think. Companies that wish to go public must adhere to certain guidelines issued by authorities such as SEBI and Stock Markets. Moreover, the policy directions of the ruling government should also be complied with. In short, IPOs should be in conformity with the IPO system followed in the concerned country. To start with, company that wishes to raise finds trough IPO must approach an investment bank to attain their help in connection with the preliminaries of IPO. The investment bank will assist the company by underwriting its shares. Underwriting is an agreement by which an investment bank undertakes to act as a middleman in the process of raising money by the issue of stocks. They, in fact act as middlemen between companies and the investing public. In the underwriting agreement between the company and its investment bank, both negotiate a deal as to the amount of money a company will raise, the type of securities to be issued, and all the details in the underwriting agreement. Some of the world renowned underwriters are Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Lehman Brothers and Morgan Stanley. The terms of underwriting agreement can be mainly of three ways, namely firm commitment basis, best efforts basis and syndicate basis. In a firm commitment basis the investment bank makes an outright purchase and resells the same to the public later. The investment bank does not make any guarantee as to the volume

of selling but assures that it will sell for and on behalf of the company in the best efforts offer. In certain cases, one investment bank cannot take all the risks in selling stocks, instead bank approaches similar banks to form a syndicate, which take risks together in the IPO.

Once the company and the investment bank agree each other on the terms and conditions of underwriting, the investment bank (or underwriter) prepares a written agreement, which shall be the sole proof of the deal between the company and underwriter. A copy of this document shall be filed with the Securities and Exchange Commission (SEC). After a careful examination of the document by SEC to ensure that the document discloses all material information regarding the company and issue such as financial statements, management background, any legal problems, where the money is to be used, and insider holdings, SEC fix a date (the effective date) by which the stock will be offered to the public. During the period (known as off cooling period) of investigation by SEC, the underwriter puts an initial prospectus (known as red herring) containing all the information about the company except for the offer price and the probable effective date of offering. Before the announcement of the effective date by SEC, the company along with underwriter will attempt to build up interest of public for the issue. After the announcement of date of offer the company and underwriter sit together to find a price for the IPO. Finding a price which will capture the market and satisfy the needs of the company is a difficult task. The price must be fixed in such a manner that both underwriter and company must agree upon it. On agreeing the price, the securities are offered to the public for subscription.

CHAPTER III

LITERATURE REVIEW

3.1 Introduction

Initial Public Offering (IPO) under pricing and long term performance has been a hot

topic for scholars and researchers across countries. Many have investigated into these and other related topics of interest to bring in novel and fruitful insights and theories on under pricing and after market performance of IPOs. As a result, they have come up results which are of immense help for scholars and practitioners. In addition to that, scholars and researchers also have found them useful for studies that fill in the research gap in the relevant area. This chapter deals with the literature review of the present topic and its related issues. Literature review accounts all the studies and findings that have been published by accredited scholars and researchers. In this

section of the research paper, research studies and writings undertaken on under pricing of IPOs and its long term performance across the world are dealt with. The studies have been arranged in a logical order by narrating only the major findings and conclusion of the writings. This chapter has two sections, namely section I and section II. Section I deals with writings related to under pricing phenomenon of IPOs and section II is meant to detail long term performance of IPOs.

CHAPTER IV

DATA ANALYSIS

4.1 Introduction

After the data have been tabulated and coded for easiness and convenience for further processing, the next step is analysis. Analysis involves the conversion of raw data into meaningful information so as to make them appropriate for arriving at logical finding and conclusions. This section of the report examines how the researcher has analyzed data and what all methods have been used. As already mentioned, two major areas are to be covered in the analysis, namely calculation of under pricing and evaluation of long term performance of the IPOs. The analysis is presented in such a manner that each IPOs initial return table is followed by the its long term performance by means of graph. The two analytical tools which have been used in the present study are discussed below:

4.2 Analytical Tool for Measuring under pricing of IPOs

P−P

IR i =

1 0

P 0

Where,

1

0

IR i = subscribers’annualreturn

P =ClosingPriceonthefirstdayof trading P = Offerprice

4.3 Analytical Tool for Measuring Long term performance of IPO

T T

BHAR iT =

∏ (1+ R )it

t =1

−∏ (1+ R mt )

t =1

Where,

IR i = subscribers’annualreturn

P =ClosingPriceonthefirstdayof trading1

P = Offer0 ricep

CHAPTER V

FINDINGS AND CONCLUSION

5.1 Introduction

The last chapter deals with the detailed examination of the data collected from secondary source to arrive at meaningful and logical findings and conclusion. This chapter presents the

major research findings that have been extracted from the results of analysis, the suggestions put forward by the researcher for the discrepancies identified in the research and the conclusion to the research study. This chapter is divided into three major segments for convenience, namely Findings, Suggestions and Conclusion.

References

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Aggarwal R, Leal R and Hernandez L, (1993), “The Aftermarket Performance of Initial Public Offerings in Latin America”, Financial Management, 22, pp. 42-53.

Allen F and Faulhaber G R, (1989), “Signaling by Under pricing in the IPO Market”, Journal of Financial Economics, 23, pp 303-323

Aussenegg W, (1997), “Short and Long-run Performance of Initial Public Offerings in the Austrian Stock Market”, Working Paper, Vienna University of Technology, Austria

Barry C and Jennings R H, (1993), “The Opening Price Performance of Initial Public Offerings of Common Stock”, Financial Management, 22, pp. 54-63.

Beatty R and Ritter J, (1986), “Investment Banking, Reputation, and the Under pricing of Initial Public Offerings”, Journal of Financial Economics, 15, pp. 213-232.

Boehmer Raymond P.H and Fishe, Ekkehart (2001) ‘Equilibrium Rationing in Initial Public Offerings of Equity’, June 14, 2001, viewed 30 December 2008,

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