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Initial Public Offering

The first equity sales by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market. It is also referred to as a "public offering." Reasons for IPO The main reason for an IPO that people usually think of is that the company wants to raise capital. The capital can then be used to invest and expand the company. An IPO allows a company to tap on the wide pool of investors in the market to raise capital, and raising capital through an IPO is a cheaper method as there is no fixed interest to be paid and fewer conditions attached. Although raising capital is one of the reasons, James C. Brau and Stanley E. Fawcett (2006) mentioned that the most important motivation for going public is to create public shares for future acquisitions. Other reasons for an IPO are that it raises the profile of companies. It builds up public awareness and increases the prestige of a company. Timing of IPO The frequency and number of initial public offerings have gone through fluctuations over time during the past decades. For example, only approximately 283 firms went public in the 1970s in the US as compared to approximately 3227 firms going public in the US during the 1980s. Thus, we can see that Initial public offerings are not stable and can vary from year to year. Economists believe that IPO activities are correlated with the economic conditions both directly and indirectly. Macroeconomic conditions indirectly affect a companys decision to have an initial public offering; macroeconomic conditions would affect the global economic climate thus affecting industry level and firm level performances. The economic climate would determine the optimal operation within each firm and thus would affect a firms decision to go public. In a positive and upward trend economy, there would be higher

probability of firms demanding funds for expansion; this would lead to firms deciding on an initial public offering as one way of funding. Lerner (1994) studied 350 privately held venture-backed biotechnology firms and concluded that these companies go public when equity valuations are high, while they employ private financing when values are lower. Pagano et al. (1998) showed that the most important determinants of IPOs are the company size and the industry market-to-book ratio. They conclude that going public lowers the borrowing cost and that entrepreneurs attempt to time their IPOs to take advantage of good market conditions. In Anh L. Tran & Bang Nam Jeon (2011), studying the US market, evidence was found that there a relationship between IPO activities and macroeconomic conditions existed. Empirical studies show that stock market performance and volatility were the most crucial factors affecting the timing of IPOS. While the Fed funds rate and the 10-year US Treasury Bond (TB) yield play a significant role in determining the amount of proceeds raised in these IPOs. It was shown in the study that stock market performance as a factor dominated all others in explaining the timing of going public. The reason was that when the stock market was performing well, there woul be a higher probability of being able to attract investors and thus also lead to higher stock returns. Entrepreneurs took advantage of better stock market performance to bring their company public due to this fact. (Source: Anh L. Tran & Bang Nam Jeon (2011): The dynamic impact of macroeconomic factors on initial public offerings: evidence from time-series analysis, Applied Economics, 43:23, 3187-3201) IPO PERFORMANCE Singapore IPO first day of trading performance IPO performance in Singapore: For stocks being listed on the Singapore stock exchange usually follow an inverted U shape curve. The stock prices usually increases, hits a peak and then decreases, this can be observed by several of the IPOs that have occurred in 2012.

The IPO price for Geo energy was 32.5 cents. It opened at 47 cents, peaked at 49 cents and closed at 43.5cents. (Oct 15 2012)

The IPO price for JB foods was 30cents. The price rose to hit a high of 42 cents before dropping and closing at 34 cents. (JUL 23 2012)

The IPO price for Courts was 77 cents. It opened at 81 cents peaked at 83 cents and closed at 8.5 cents (OCT 19 2012)

Far East hospitality trust IPO price was 90cents. Price peaked at 1 dollar. Ascendas Hospitality trust IPO price 89cent; closed at approximately 86 cents. IPO Performance in the US Data from a database company shows that in 2012, IPO stocks usually perform well, with the stock price always closing higher than the offer price on the first day of trading . Furthermore, winner stocks tend to outperform the loser stocks in terms of magnitude in the respective directions.

Seeking Alpha has tracked IPOs in the early part of 2012. There has been 50 IPOs over the Oct 2011 to Mar 2012. Of the 50 IPOs, 41 (82%) are up from their IPO price and 36 (72%) are

up from their opening price. The average change of the 50 stocks from their IPO price to date is 27.46%, while the average change from their opening price to date is 15.92%. IPO first day trading Performance conclusion In general we can see that upon trading commencement, the first day performance of IPOs do quite well. However, in the long run, the performance may dwindle depending individually on each company, for reasons that will be discussed below. Investors who purchase the IPO and sell them off during the first day of trading, overall, the investor should have made gains, as the numbers of winners are higher in numbers and the magnitudes of the wins are higher as well. One of the reasons for the price movement observations is that the value of the shares being sold in an IPO are inherently subjected to great uncertainty and this results in underpricing. Rock (1986) argues that if both informed and uninformed investors are to purchase shares in the IPO, under-pricing is necessary to attract uninformed investors. Similarly, Benveniste and Spindt (1989) argue that if some investors have better information about the value of the shares than the underwriter, the underwriter can extract this information by rewarding informed investors with under-priced shares. Also, under-pricing may serve a marketing function. Welch (1992) models the idea that under-pricing can cause a domino or cascade effect among investors that raises demand for the issue. Habib and Ljungqvist (2001) argue that under-pricing allows for cost savings in other areas of marketing the issue One of the issues for retail investors for such an investment strategy is that many IPOs are usually oversubscribed. It is hard to get the exact number that you want, or in the worst case get any at all because investors have to ballot for the stocks. Furthermore, the demand is pushed up even more due to the low cost of purchase fee, a mere 2 dollars in Singapore, which is a lot cheaper then the usual brokerage fees in Singapore. IPO Long Run Performance One of the reasons for abnormal positive and negative returns for IPOs in the long run is due to information risk. Information risk is priced by investors and cannot be assessed ex-ante for an IPO, thus investors have to form an expectation. The pricing of the information risk is

an expectation and may not be exact or accurate. The pricing of the information risk may be initially underestimated (overestimated), and in the long run the stock price would then correct itself downward (upward) as new and more firm-specific information surfaces up and come to the knowledge of investors. This gradual correction process leads to what seems to be abnormal returns of IPOs over a long period of time, as updating of the price requires sufficient new information that does not all come immediately at one go, but rather is dessimenated over a lengthy period of time.(Information Risk and Long-Run Performance of Initial Public Offerings (2009) Authors: Frank Ecker) Another reason for price changes for IPO in the long run is due to correction of investor optimism at the start. Investor over-optimisms at the beginning of issues are sometimes due to issuing companies reporting unusually high earnings. The issuing company does this by adopting a discretionary accounting accrual adjustment. This raises reported earnings relative to actual cash flows, however investors are not aware that the earnings are inflated by the use of accrurals. Overtime, as more information leaks out and investors are able to observe that the firms are unable to maintain their earnings momentum, they lose their optimism and the prices correct. The greater the earnings management (positive accrual) at the time of offering the larger the price correction down the road when the price corrects. (Siew Hong Teoh, T. J. Wong 1998) Paul A Gompers and Josh Lerner (2001) did a study on a sample of over 3,661 IPOs between 1935 and 1972; The result was that the relative performance of IPOs depends on the method of examining performance. One methodology suggests that this sample underperforms; others suggest superior performance. When event-time buy-and-hold abnormal returns are used for testing, underperformance is the concluded; however underperformance disappears when cumulative abnormal returns are used instead. The weak evidence for underperformance and the failure to observe a consistent pattern raises doubts about whether a unique IPO effect indeed exists.

Conclusion Data and studies show that performance in the very short run (First day of trading) for IPOs are generally positive; however, there are several theories to explain price movements in the long run which are not conclusive.

Ang Wei Ming

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