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When a company's initial public offering, or IPO, is undervalued, that company is selling shares of stock for less than their market price. It's a great deal for investors, who get a bargain price and the ability to turn a quick profit. But it can be a catastrophe for the company, which loses out on the chance to raise as much money as possible.
The Purpose of an IPO
As the name suggests, an initial public offering is the first time a company makes shares of its stock available to the public. Although an IPO may allow company founders and early investors to "strike it rich" by converting their ownership of the company to valuable stock that they can sell, the primary purpose of the IPO is to raise capital for the company. The price the company sets for the shares at the IPO should maximize the amount of money it raises.
A company determines the price to set for its shares by working with an investment bank that tries to gauge market interest. An "undervalued" IPO is one in which the initial price the company sets for the shares is lower than what investors are actually willing to pay. If a company goes public at, say, $20 a share but the market is able to support a price of $25, then the IPO is undervalued. Initial public offerings can be overvalued, too; that's when the company is asking more for its shares than the market is willing to pay.
When an IPO is significantly undervalued, it's the company itself that's the big loser. Though the news media loves to report on offerings with a big "pop" -- shares that skyrocket in value after the IPO -- such IPOs are not really successes. That's because once a company sells a share to the public, it no longer receives any money from it, no matter how high the price goes. Go back to the company that offers shares for $20 when the market is willing to pay $25. By selling for $20, the company left $5 on the table with each share it sold. That money gets scooped up by whoever buys the shares at $20. Those buyers can turn around and sell the shares for $25 and pocket a quick profit.
All that said, a company can benefit when an IPO is slightly undervalued. The worst thing that can happen is for the company to make shares available, and no one wants to buy them because they're overvalued. The initial buyers of an IPO typically are large institutional investors that have committed to buy a certain number of shares. They are taking a risk on the stock, and they want to be compensated for that risk. With a slightly undervalued IPO, those investors can step in, buy the stock and resell it on the market. They make a tidy profit, the company still raises a lot of money, and the business enjoys positive publicity generated by a nice -- but not too nice -- pop.
- Stock Market image by Paul Heasman from Fotolia.com