After Market Pricing Performance of Initial Public Offerings (IPOs)

Prologue

Going public, that is, selling company’s shares in capital market, is one form of raising finance and it is generally done through initial public offerings (IPOs). Usually, in IPOs shares are sold to public at a price lesser than the first day trading. This is the reason under pricing is called costly affair for the corporate houses. Despite this, researches by Ritter (1991) and Levis (1993) have given evidence that under pricing is a common phenomenon prevailing in majority or almost all equity markets. This is the reason, studies of short- and long-run performance of IPOs have created much hype in the world of corporate and academics. Further, research by Bessler and Thies (2007) and others have tried to address this “market anomaly” which comes with not only high return but also with high risk. Almost in all equity markets, studies on IPOs have found significant under pricing in the primary market and therefore substantial initial return in the secondary market.

Three well-documented anomalies associated with IPOs are under pricing, hot issue market, and long-run under performance, and therefore many studies are trying to find out that whether these anomalies are examples of market inefficiency or caused by herd behavior (Rajan & Servaes, 1997). One view for this anomaly is that it is due to institutional constraints.

Empirical examination in this area confirms two types of phenomena related to IPOs. First, IPOs at the time of listing are underpriced and this is the reason investors are able to earn abnormal higher rate of return compared to market; second, IPOs are overpriced and so under perform in the long run (Purnanadam & Swaminathan, 2004; Ritter, 1991).

The paper focuses on to examine post-issue share price performance of IPOs issued during January 2004 and December 2013 and for that post-issue IPOs performance has been studied with respect to list price up to 200 days from the listing day. To empirically find out the long-run price performance of IPOs, it was tested based on average abnormal return (AAR) and cumulative abnormal return (CAR). Further, long-run performance was tested by applying methodologies like “wealth relatives” (WRs), “buy and hold abnormal return” (BHAR), and short run by applying “market adjusted abnormal return” (MAAR).

Extant Literature

Gompers and Lerner (2003) have examined the performance for five years after listing of 3,661 US IPOs for the period 1935 to 1972. The research found some underperformance when event time buy-and-hold abnormal returns are used. The calendar time analysis says that IPOs have provided as much return as the market over the entire sample period. However, the research says that no concrete finding came out from the study as the relative performance of a IPOs sample depends on the method of examining performance as the one method suggests that this sample underperformed, while other suggests superior performance. Contrary to this, study by Purnanadam and Swaminathan (2004) provided more linear picture as their findings show that IPOs are overvalued at the offer price, increases afterword and revert to fair value in the long run, and found that IPOs can be both overvalued and underpriced at the same time. Welch (1989) empirically presented a signaling model in which high-quality firms under price IPOs in order to obtain a higher price at seasoned offerings. This was rigorously addressed by Ghosh (2005) and the author went with more time-based examination and concluded that IPOs with large issue size and those that went for subsequent offers underpriced less. The author found that compared to international evidence, there was less under pricing during the high volume boom period than during the slump period in the Indian market and during the boom period new issues belonging to business groups underpriced more than their stand-alone counter parts to signal their better quality, and par issued recorded more initial returns than did issues with premiums. Like Ghosh (2005), Zheng and Stangeland (2007) examined variables like growth rate in sales, EBITDA, and earnings as measures of firm quality etc., and found that IPO firms with greater under pricing is positively related to growth rate in sales and EBITDA. Ritter (1991) studied the time and industry dependence of the long-run performance of IPOs. As per the author’s findings investing in the IPO at the end of the first day trading and holding them up to 3 years results into 83 cents for each dollar invested. Moreover, the evidence indicates that the offering price is not too low, but the first after market price is high. That is the reason that it is the unresolved issue that there is a long-run under performance and short-term under pricing phenomena.

Loughran, Ritter, and Rydqvist (1994) discussed short-run and long-run performance of the companies going public in many countries. Evidence indicates that East Asian economies successfully time their offerings for periods when valuations are high and investors receive low return in the long run. In a similar path, Hopp and Dreher (2013) analyzed the determinants of IPOs using panel data for 24 countries for the period 1988–2005 and concluded that under pricing is higher in countries with stronger protection of outside investors, suggesting that incumbent managers try to use under pricing as a tool to safeguard their private benefit as control when going public. Levis (1993) has empirically studied 712 IPOs listed on the London Stock Exchange. This study has recorded an average first day return of 14.3 percent. It shows that IPOs in the UK underperformed a number of relevant benchmarks in the first 36 months from the day of their listing. In line with this, work by Burrowes and Jones (2004) investigated the performance of IPOs on the New Alternative Investment Market and found that IPOs listed on AIM at the London Stock Exchange appear to be only conservatively mispriced when contrasted to main board IPO listings in the US, UK, and other countries. When it was studied region-wise, Tsangarakis (2004) found that Greek IPOs had an average large positive return and provides positive one year return related to offer price. An analysis by Corhay, Teo, and Reza (2002) confirmed that IPOs tend to outperform the market with a positive cumulative adjusted market return (CAR) of 41.7 percent over a three-year period from listing day and found that the size of an IPO is found to be inversely related to CAR.

Results by Jain and Kini (1994) indicated that IPO firms are unable to continue their pre-performance level and even if sample IPO firms have shown high growth in sales and post-issue capital expenditure, their profitability has declined. Similar to Jain and Kini (1994), research by Jain and Padmavathi (2012) cited reasons for the underperformance of the IPOs and concluded that under pricing is the result of investors’ high willingness to pay, high demand of the issue, high firm value, and high fluctuations in the market returns. The result shows that IPOs of high-value firms are more under priced in India. Also under pricing is high when index is highly volatile in the market. Aggarwal and Rivoli (1990) concluded that there are two reasons behind positive abnormal return in IPO, first the explanation is that under writers systematically price IPOs below their intrinsic value and second possibility is that IPOs are subject to over valuation or fads in early aftermarket trading. The results tested by the researchers in their research are of second type. Empirical evidence proves that IPOs provide positive abnormal return in the short run but loss in the long run.

Like Ritter (1991), a seminal work done by Sahoo and Rajib (2010) studied performance of 92 IPOs. The paper noted that on an average Indian IPOs are underpriced to the extent of 46.55 percent on the listing day compared to the market index. The paper has tested long-run performance of the IPOs by taking 36 months after their issuance and it finds that under price is found in the initial year of trading, that is, up to 12 months and after that under performance, that is, overpriced is observed which contradicts with the study by Purnanadam and Swaminathan (2004) and confirms the study by Aggarwal and Rivoli (1990). Contrary to earlier work, Teoh, Welch, and Wong (1998) studied from the issuers’ front and provided empirical evidence that issuers with unusual high accruals in the IPO year experience poor returns, that is, it results in capital loss for such firms.

Data and Methodology

Capital Asset Pricing Model (CAPM)

As per CAPM the expected return of a security equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The formula of the CAPM is:

R = R ​ f + β ( R m − R ​ f )

(1)

where

R, required return on a stock

β, beta (risk co-efficient) of the stock

R_m, market rate of return

R_f, risk-free rate of return

The beta value was found out from security-wise data and market return data. The risk-free rate of return considered here is the 91-day treasury bills rate of 8 percent and has been converted into daily rate by dividing the yearly rate by 365 (days).

For example, 8/365 = 0.021917808.

The market’s reaction to the IPOs is measured using daily stock return data to compute abnormal returns. These abnormal returns are a measure of the stockholder’s actual return minus return generated by CAPM model. The daily abnormal return for the security is estimated by

A R t = R t − E ( R t )

(2)

where t = relative to day, AR _t = abnormal return on the security for the day t, R_{t = actual return on the security for day t, and E(Rt) = predicted or expected rate of return as per CAPM model on the security for day t.}

First, the AARs for each relative day t are calculated across the securities. Daily average CARs are the sum of the AAR over event time. In other words, CAR is defined as the sum of previous daily average residuals for each trading day (Corhay et al., 2002).

Wealth Relatives

Levis (1993) and Sahoo and Rajib (2010) examined the long-run performance of IPOs in UK and Indian market, respectively, by calculating wealth relatives.

The performance of group of IPOs showing the wealth relatives is evaluated for a specific point of time. WR is defined as follows:

W R i t = 1 + 1 N ∑ i = 1 N R i t 1 + 1 N ∑ i = 1 N R m t

(3)

where R_it = is the return of the individual IPO stocks I on day t from offer day and R_mt = is the market index return for BSE for the corresponding time period.

The WRs of more than one indicate better performance for IPOs over the market index, while a value of less than one indicate underperformance of IPOs.

Market Adjusted Abnormal Return (MAAR)

Gompers and Lerner (2003) and Sahoo and Rajib (2010) calculated MAAR for the listing day of the security on the day 1 and benchmark return on that day.

M A R R = [ ( 1 + R t ) / ( 1 + R m ) − 1 ] * 100

(4)

where MAAR_i1 is the market-adjusted abnormal rate of return for the IPO i on day 1, R_t is the percentage change in list price vis-à-vis offer price on day 1. R_m is the percentage change in the index on the day of listing of the IPO.

Buy and Hold Abnormal Return (BHAR)

Calculation of BHAR takes into account both offer price and list price. Like portfolio performance evaluation method, the computation of BHAR takes care about the change in the wealth of investors by assuming that the amount invested on the initial day is hold till the specified period (here 200 days). The rise/fall in the return from initial day to till holding day is compared with respect to benchmark index. First of all BHARs were calculated on a daily basis for an individual IPOs and then average of BHAR was found out by dividing it with number of days. Like CAR mentioned above, cumulative BHAR was calculated for each IPOs. The average BHAR demonstrate the overall performance of the IPOs for the concerned time period. Below is the formula to calculate BHAR and average BHAR.

B H A R i T = ∏ t = 1 T ( 1 + R i t ) − ∏ t = 1 T ( 1 + R m t )

(5)

B H A R ─ = 1 N ∑ i = 1 N B H A R i T

(6)

The positive (negative) value of the BHAR for the concerned time period is interpreted as good (bad) performance of the IPOs vis-à-vis market index. Like portfolios of securities, BHAR helps to compare the performance of the IPOs with benchmark index. In other words, day-wise BHAR, or computation of BHAR for a particular time window indicates, starting from initial day to within how many days, investors can get positive (negative) return or during which time window return of the BHAR is good (bad).

Empirical Examination

As mentioned in the Data and Methodology section, CAR and cumulative BHAR were calculated for a different time windows. Table 1 infers that CAR (or in other words AAR on day 1) on the day 1 and cumulative BHAR generated by all 183 securities is very impressive. With the exception of 1 to 3 days and 1 to 120 days CAR, and cumulative BHAR decreases from day 1 to till 1 to 200 days and shows negative return in both columns 2 and 3 for 1 to 180 days and 1 to 200 days. Therefore, it can be summarized that IPOs are underpriced and show over performance just on initial days and immediate time period. For a medium-term time window, shows nominal return as it is less than even risk-free securities and in a longer term provides negative return. The consistency of trend and result showed in columns 2 and 3 of Table 1 shows that by two different methods also, interpretation is same. The mere fundamental analysis done by using CAR and cumulative BHAR reveals that in a long term, IPOs are not a good bet to rely upon. This is consistent with the findings of Sahoo and Rajib (2010) and Aggarwal and Rivoli (1990), while contradicts with Purnanadam and Swaminathan (2004).

The AAR shows the overall performance of the all 183 IPOs for a day 1 to till 200 days considered here. Figure 1 depicts that on the first day of listing IPOs provide whooping return of 15.73 percent which later on remarkably decreases to 1.02 percent and then hovers around –1.71 to 0.51 percent from third day to till 200 days. However, it is difficult to analyze overall performance of the IPOs based on AAR only as it just average outs the performance of all 183 IPOs on a day-to-day basis. To get further insight in this regard, CAR was computed as shown in the Data and Methodology.

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Table 1.

Cumulative Abnormal Return and Cumulative BHAR of IPOs

Time Window	Cumulative Abnormal Return (CAR)	Cumulative BHAR
1 day	15.73295	15.99541
1–3 days	16.59994	16.92436
1–5 days	15.50741	15.79206
1–7 days	14.32504	14.53419
1–15 days	12.98584	13.19249
1–30 days	9.589185	9.784714
1–60 days	7.635767	8.055282
1–90 days	2.990367	3.852994
1–120 days	3.716205	4.86145
1–150 days	0.92183	1.941139
1–180 days	–3.96527	–2.48848
1–200 days	–6.72319	–5.35796

Source: Author’s calculation.

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Figure 1.

Source: Author’s calculation.

Figure 2 presents the CAR of all considered IPOs here and shows that from short- to medium-term duration, it provides return near to 7.63 percent on 1–60 days which is quite near to the return provided by risk-free securities in the market. After that return falls and come to close to 3.00 percent for a time period of 1 to 90 days which then falls to till 109 days and further rises to till 140 days and fluctuates between 1.94 and 3.89 percent. 140 days onwards, it shows downward trend and remains marginally positive (0.08 percent) till 157 days and then falls to the extent of −6.73 percent on 200 days. One can also reveal that IPOs examined on the basis of CAR provides positive return till 140 days, which is more by 80 days than the medium-term time window (60 days) considered for the study; however, till 60 days it shows gradual falls to the extent of close to 3 percent and then further upward trend followed by the downward trend. Therefore, period considered after medium-term time window brings more uncertainty than consistency.

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Figure 2.

Source: Author’s calculation.

Table 2 reports results of WRs of 183 IPOs for a time framework considered for 3 days to 200 days. In the table, it can be observed that WR values are greater than 1 for a time period of 3 days to till 60 days. The greater than 1 value of WRs indicates superior performance of IPOs for that time period compared to market index. Value less than 1 indicates under performance compared to market index. Therefore, based on the WRs computation, it can be interpreted that IPOs provide better and more than market index return for short to medium term as it can be noted that value of WR falls from 1.056 to 1.031 and so on. When it comes to 60 and 90 days, IPOs perform at par with the market and later on their performance falls compared to market. This WR-based analysis confirms with the work done by Sahoo and Rajib (2010) and Aggarwal and Rivoli (1990), while contradicts with Purnanadam and Swaminathan (2004).

Table 3 further shows snapshots of the WRs with respect to time and number of IPOs, and it reveals that initially up to 30 days majority of the IPOs are underpriced and few are overpriced. However, it can be also observed that the over performance (underperformance) decreases (increases) gradually with respect to time. In confirmation with Table 2, Table 3 summarizes that till medium term, that is, as considered in the Data and Methodology, slightly more than half of the IPOs, that is, here 53.14 percent, are underpriced and later on that means for a longer-term basis, it shows underperformance.

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Table 2.

Day-wise Wealth Relatives (WR) of IPOs

Time Period	WRs
3 days	1.056455
5 days	1.031624
10 days	1.013604
30 days	1.003427
60 days	1.001357
90 days	1.000455
180 days	0.999857
200 days	0.99976

Source: Author’s calculation.

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Table 3.

Wealth Relatives of IPOs

	WRs
	Greater than One (underpriced)		Less than One (overpriced)		Total No. of IPOs
	No. of IPOs	%	No. of IPOs	%	No. of IPOs	%
3 days	124	68	59	32	183	100
5 days	121	66.29	62	33.71	183	100
10 days	113	61.71	70	38.29	183	100
30 days	105	57.14	78	42.86	183	100
60 days	97	53.14	86	46.85	183	100
90 days	88	48	95	52	183	100
200 days	79	43.43	104	56.57	183	100

Source: Author’s calculation.

Negative BHAR can be interpreted as IPOs underperforming compared to the index return for the considered time period while positive BHAR indicates IPOs have performed better than the market. The empirical result in Figure 3 report is fluctuating but positive BHAR till 171 days and negative return hovering to −0.00094 to −5.46 percent for 172 to till 200 days. Figure 3 shows similar pattern as Figure 2 and suggests as per BHAR, IPOs are also good investment tool for initial day to short-term to medium-term time period as till 60 days as per BHAR it provides 8.055 percent return.

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Figure 3.

Source: Author’s calculation.

To find the overall performance of the portfolio of IPOs for specific time period, as per BHAR method; average BHAR for the entire sample is calculated by taking equal weight. The average portfolio return was calculated for the entire sample of 183 IPOs for a time period of 0 to 10 days to till 0 to 200 days. From Table 4, it can be inferred that IPOs are able to generate comparatively good return in the initial time period than the later on. It can be observed that the portfolio return computed from the BHAR is the highest for the initial 0 to 10 days and then later on it decreases with exception for a time period of 0 to 120 days where it has slightly improved. Therefore, once again it is confirmed that IPOs are good bet to book the return in the initial phase as the table shows negative return for a time period of 0 to 180 days and 200 days. In confirmation to Tables 2 and 3 and WRs frame work, IPOs studied as a bunch of securities and analyzed from BHAR model, provide better return for initial to medium-term time period and later on their return deteriorates.

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Table 4.

Portfolio of the IPOs Constructed as per BHAR

Period	Portfolio Return
0–10 days	0.068016
0–20 days	0.061482
0–30 days	0.051512
0–60 days	0.040888
0–90 days	0.020576
0–120 days	0.023427
0–150 days	0.010451
0–180 days	–0.01275
0–200 days	–0.02679

Source: Author’s calculation.

MAAR was computed as the difference of the first day return calculated for the security i with the benchmark return on that day. From Figure 4, it can be observed that IPOs in initial days provide good return which is ranging from negative −50 to more than 250 percent positive. Hence in quick term basis, IPOs are good for investment in Indian market. Average MAAR for all sample IPOs is15.68746 percent for the sample considered here.

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Figure 4.

Source: Author’s calculation.

Findings and Conclusions

In this paper, performance of the IPOs for a listing day to till short-to-medium and long-term time framework is studied by applying different methods. The purpose here is to check consistency or reliability of the results generated by them. There are many studies that have tried to study the same. However, there are a few studies that have examined and considered sample with all methods or else their sample and period of coverage are not sufficient. By considering both reasonable longer period for study (2003 to 2013) and sample (183 firms without any other event which can bias the study), the present paper finds and concludes the followings.

An examination of all 183 IPOs for an immediate to medium- to long-term time period by considering CAR and cumulative BHAR shows consistent trends and results. The analysis by both the methods indicates that IPOs are underperformed on the first day and immediate time period, after wards the return decreases, and from medium- to longer-term time framework it becomes negative which agrees with Sahoo and Rajib (2010) and Aggarwal and Rivoli (1990) while contradicts with Purnanadam and Swaminathan (2004).

Even if AAR does not provide any meaningful insights, Figure 1 gives an idea that only on the first day to till the third day on an average IPOs provide good return, later on for all remaining days to till 200 days, it ranges in a very narrow range of –1.71 to 0.51 percent. For a more insightful finding, CAR was plotted in Figure 2 and it reveals that in a shorter term, that is, from 1 to 10 days, return hovers around 12–15 percent; and for a medium-term period it provides near to risk-free return, while in a longer term it provides very nominal (1.94–3.89 percent) to negative return. Thus, analysis carried out in Figure 2 confirms with CAR and cumulative BHAR. In a similar way, analyses presented in the form of Figures 2 and 3 show same pattern and result. Moreover, for a period of medium and longer term it shows more uncertainty. Further, based on WRs also, similar interpretation was built as IPOs are a good bet to generate wealth in a shorter-term time framework, as returns are quite close to market in a medium term and there is a deterioration of wealth in a longer term. Thus, as per WRs, it can be summarized that even if they are hold till medium term, they do not help to contribute.

When WRs were studied in terms of number of IPOs, Table 3 summarizes a very interesting pattern and shows that number of IPOs that have over (under) performed decrease (increase) as number of days increase which is in line with the analysis studied in this paper.

When portfolio was constructed based on BHAR, it provides same judgement as derived from mentioned studies in this paper. In MAAR, all 183 IPOs return was analyzed in comparison of market return on day 1; it showed that average return provided is 15.68746 percent. In short, conclusion is that IPOs are a good bet to rely upon from immediate to short run and at most till medium term.