Is the Whole More Than the Sum of Its Parts? Underpricing and Long-Run IPO Performance

Abstract

We use the estimate of an IPO’s intrinsic value derived from its initial price range and the degree to which the overallotment option is exercised to decompose IPO underpricing into a Market Inefficiency and an Underwriter Bias component. The former reflects the difference between the closing price on the first day of trading and the intrinsic price and the latter the difference between the intrinsic price and the offer price. We show that although an investment strategy that goes long on undervalued and short on overvalued IPOs based on underpricing does not result in any significant return profitability, a similar strategy based on Underwriter Bias (Market Inefficiency) earns statistically and economically significant returns of 28% (15%) over the three-year period following the IPO. Multivariate results indicate that Underwriter Bias is strongly positively related to future returns but Market Inefficiency does not exhibit significant incremental information content. Our results are robust to numerous sensitivity analyses, including different model specification and different measures of long-run returns. We conclude that the inability of prior research to document a relation between IPO underpricing and future return performance can be explained by the counteracting effects of the two components of underpricing and that the IPO’s future long-run return performance can be predicted by the deviation of the intrinsic value from the offer price.