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Why is it hard to buy shares in an IPO? Answer
The reason why it is hard to buy shares in an IPO is because demand is higher than supply. That's true. But why demand for shares in an IPO is so high? (Empirically, most IPOs in the US are oversubscribed). It is because IPOs are usually underpriced.
In period from 1980-2001, on average, if an investor can buy shares in an IPO and sell them immediately at the end of the first trading day, she can earn a return of 18.8% [1]. Imagine that you get up in the morning with $1,000 and go to bed at night with $1,188 virtually without doing anything. It seems to be more profitable than drug trafficking. The first-day return is even more dramatic during the Dotcom bubble (late 1990s) when an investor buying shares of internet firms could earn an average first-day return of 89% [2].
Several studies have attempted to explain why IPOs are underpriced but the evidence so far is not conclusive. Some well-known explanations in the literature are [1]:
(1) High-quality firms want to signal that they are good firms (as opposed to bad firms) by "leaving money on the table" in the IPO. In fact, empirical evidence about this signaling theory is mixed.
(2) Information revelation theory: issuers reward investors for revealing their private information about how they value the issuers' shares by underpricing the IPOs (But this seems to be inefficient to explain the big underpricing in IPOs).
(3) As underwriters know more than issuers about the market demand, to induce underwriters to exert effort to market the issuer’s shares, it is optimal for the issuer to permit some underpricing, because the issuer cannot monitor the underwriter without cost. (But some studies found that underwriters themselves are also underpriced when they go public)
(4) Underpricing is a substitute for costly marketing expenditures (this cannot explain the severe underpricing of IPOs during the Internet bubble)
(5) Issuers underprice their IPOs to avoid possible legal liability if they subsequently performing poorly. (However, there is evidence not in favor of this argument: sued IPOs actually have higher, not lower underpricing; countries in which the likelihood of being sued is much lower than U.S also have similar levels of underpricing)
(6) Underwriters could not justify a higher offer price on Internet IPOs, perhaps out of legal liability concerns, given the already lofty valuations on these companies. Therefore, IPOs were more underpriced during the Dotcom bubble. (This explanation is not convincing because investment banking firms were making other efforts to encourage overvaluations during the Internet bubble)
(7) Trading volume in the aftermarket is higher, the greater underpriced IPOs (so underwriters can benefit from higher future revenue)
One thing to note is that the process of IPO in the US is fundamentally different from that in Vietnam. Therefore, some of these explanations may seems counterintuitive if we think about them in the context of Vietnamese stock exchange.
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