Empirical Investigation of Pricing Performance of Initial Public Offerings (IPOs); Evidence from Pakistan

Abstract

Over the last four decades, the performance of initial public offerings (IPOs) has remained an interesting topic for the academia, researchers and policy makers. Questions pertaining to how the prices of new issues behave in short-, intermediate- and long-term have been shown to have economic and academic implications. Empirical evidence suggests that IPOs significantly outperform most benchmarks from the listing day to one-month trading periods. The conclusions reached in studies of longer-term IPO performance have been controversial because researchers generally disagree on the methodologies used to identify longer-term abnormal performance. The problems investigated in this study are whether: (a) IPOs generate abnormal returns on initial trading day and subsequently in short- and intermediate-term and (b) IPOs systematically produce abnormal price performance. The purpose of this study is to assess whether IPOs produce abnormal returns over a period of six-months and to identify abnormal IPO performance over three-year period lasting from issuance to the three years anniversary of the newly issued shares. The research has accomplished this by developing matched-firm benchmark, based on market capitalization, to gauge abnormal performance using event- and calendar-time strategies. In addition, this study has investigated the determinants of short-, intermediate- and long-term performance using Extreme Bounds Analysis, which analyzes the sensitivity and robustness of explanatory variables and identifies true predictors. Moreover, this study has examined the growth rate implicit in offer prices using a reverse engineering DCF model. Based upon the implicit growth rate, the research will determine the estimated degree of overvaluation of IPOs by underwriters. The findings of this study are that: (a) IPOs outperformed in short-term, which indicates that investors can earn significant abnormal returns up to 15-trading day from listing day, (b) IPOs outperformed in intermediate-term, which illustrates significance of abnormal returns over two months of trading, (c) IPOs underperformed over three-year period, and (d) the growth rate embedded in IPO prices illustrating that on average the cash flow of IPO firm is expected to grow by one-fourth annually over five-year. The robust factors influencing short-term and intermediate performance include: oversubscription, aftermarket risk level of the IPO, offer price, rate of return on assets and percentage of shares offered. In terms of longer-term IPO underperformance, the observed pattern is not always statistically significant. Equal-weighted buy-and-hold abnormal returns and cumulative abnormal returns are used to find true predictors of three-year underperformance. The results suggest that underpricing, financial leverage, hot activity period, issue proceeds, oversubscription, age of the firm, aftermarket risk level of the IPO, post issue promoters‟ holding and affiliations with textiles, technology & communications and other industries caused long-term underperformance. This study concluded that short-term implied growth rate, market momentum, firm‟s age and size of sales significantly affect longer-term IPO performance. These findings provide opposition to the theory of market efficiency and infer that there is an unfair distribution in the premarket IPO pricing and allocation process. A review of the pre-market pricing as well as the method of allocation may bring significant positive change; revisions to the process could avert unfair benefits obtained by investors with privileged premarket IPO allocations, which would provide identical opportunities for investors participate in the price discovery process.