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Journal of Corporate Finance 42 (2017) 247–266
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Journal of Corporate Finance

journal homepage: www.elsevier.com/locate/jcorpfin
IPO market timing with uncertain aftermarket retail demand

Francisco Santos
Norwegian School of Economics, Department of Finance, Helleveien 30, Bergen 5045, Norway
A R T I C L E I N F O A B S T R A C T
Article history: We develop a simple model of IPO timing with uncertain aftermarket retail demand. Firms
Received 21 February 2016 prefer to go public when they expect to exploit sentiment-driven investors’ overvalua-
Received in revised form 21 November 2016 tions by setting offer prices above fundamental value. However, some firms have profitable
Accepted 23 November 2016 investment opportunities that require immediate financing. This generates two empirical
Available online 27 November 2016
predictions: (i) the quality of the issuers’ investments and (ii) their long-run performance
decrease with expected retail demand. Using average IPO first-day returns as a proxy for
JEL classification: retail demand, we find strong empirical support for the model. First, following the IPO, issuers
G14
in low-underpricing periods become more profitable and have higher investment rates than
G24
their peers. In contrast, issuers in high-underpricing periods have similar investment rates as
G32
their control firms, but become less profitable. Second, issuers in high-underpricing periods
Keywords:
tend to underperform in the long-run, while issuers in low-underpricing periods do not.
Behavioral finance © 2016 Published by Elsevier B.V.
Initial public offerings
Investor sentiment
Market timing
1. Introduction
An initial public offering (IPO) is an important step in a firm’s life. Firms go public to get access to capital markets and to
allow owners to diversify their wealth. A pervasive characteristic of the IPO market is the existence of large first-day returns,
so-called underpricing, averaging 20% over the last 40 years in the U.S. There are a number of explanations for this underpricing
proposed in the literature, ranging from information asymmetries and conflicts of interests to investor irrationality.1
Although first-day returns are on average positive, the magnitude varies substantially over time. Interestingly, Lowry and
William Schwert (2002) note that, as underpricing increases, more firms go public. The timing of issuing activity is puzzling
because high first-day returns imply that firms leave large amounts of money for investors in the aftermarket. This paper
provides an explanation for this puzzle.
We develop a simple model that predicts the timing of going public for firms whose benefits from remaining private are
relatively small. There are firms with profitable, but short-lived, investment opportunities (Good) that require external equity
financing and firms without any projects (Bad). Firms know their own type and require an offer price of at least fundamental
value to consider going public. In the offering, the whole issue is allocated to fully informed intermediaries, who in turn try to
E-mail address: francisco.santos@nhh.no (F. Santos).

1
See for example Ibbotson (1975), Ibbotson et al. (1988), Logue (1973), McDonald and Fisher (1972), Ritter (1984, 1991), Ritter and Welch (2002) , and
Loughran and Ritter (2002) , among others.
http://dx.doi.org/10.1016/j.jcorpfin.2016.11.013
0929-1199/© 2016 Published by Elsevier B.V.
248 F. Santos / Journal of Corporate Finance 42 (2017) 247–266
sell these shares to retail investors in the aftermarket. The main driver of the IPO timing decision is the expected aftermarket
demand from retail investors.
As in Ljungqvist et al. (2006), retail investors are overly exuberant in certain periods and drive demand for IPO shares in
the aftermarket. Ceteris paribus, firms prefer to go public in these periods because they can set offer prices above fundamental
value, exploiting sentiment-driven investors’ overvaluations. However, at the time issuers decide to go public, there is some
uncertainty whether retail investors will be present in the aftermarket. Hence, offer prices are a function of expected aftermarket
retail demand. The more likely the presence of retail investors in the aftermarket, the higher the offering price.
When expected retail demand is high, offer prices significantly exceed fundamental value and all firms go public. In contrast,
when expected demand is low, firms without profitable projects postpone the IPO until market conditions have improved. Good
firms, however, loose their investment opportunities from waiting due to, for example, competitors moving in. Thus, if the net
present value (NPV) of the project is sufficiently high, Good firms are better off going public even when market conditions are
unfavorable. As a result, the investment opportunities of the issuing firms vary with sentiment-driven demand.
We test our model in a sample of 6272 U.S. IPO firms over the period 1973–2009.2 In the spirit of Baker and Wurgler (2006),
we use periods of underpricing as a proxy for investor sentiment. To verify this critical assumption, we show that periods of
high underpricing are characterized by high retail demand and sentiment. Specifically, we observe, on the first trading day, 56%
higher turnover and almost 300% more trades than in periods of low underpricing. Moreover, investors react more favorably
to earnings announcements in high-underpricing periods: the two-day cumulative abnormal return (CAR) is on average 0.5%
higher, reflecting increased investor optimism.
There are two empirical implications of our model. The first is that firms going public in low-underpricing periods have, on
average, better investment opportunities than issuers in high-underpricing periods. To test this prediction, we compute post-
IPO operating profitability and investment rates of issuers relative to a control group of firms matched on industry, market
capitalization, size and profitability.
We regress these peer-adjusted measures on the level of underpricing in the market at the time of the IPO. We find that,
one and three years after the IPO, issuers in low-underpricing periods become more profitable and have higher capital expendi-
ture than their control firms. In contrast, firms in high-underpricing periods have insignificant peer-adjusted investment rates,
but become significantly less profitable than their matched firms. The results suggest that issuers in low-underpricing periods
use the IPO proceeds to exercise investment opportunities, while issuers in high-underpricing periods lack profitable projects,
consistent with our model.
Our model also provides predictions for IPO firms’ long-run performance. Recall that offer prices exceed fundamental value
and increase with expected retail demand. Aftermarket prices depend on the realization of this demand. If demand is high,
sentiment-driven retail investors generate positive first-day returns, further increasing the deviation from fundamental value.
If demand is low, however, intermediaries cannot sell the IPO shares and the aftermarket price remains at the offer price. This
generates the second empirical implication: IPOs in high-underpricing periods underperform in the long-run, both relative to
the offer price and the first-day closing price.
We test this prediction by computing five-year wealth ratios (WR), defined as the value from investing at the first-day closing
price with a five-year horizon in a portfolio of IPO firms relative to a portfolio of matched firms. Issuers in low-underpricing
periods perform at par with their control group, with a WR of 0.95. In contrast, issuers in high-underpricing periods significantly
underperform their peers. Their five-year buy-and-hold return is −1 %, compared to 70% for the portfolio of matched firms, for
a WR of 0.51.
Repeating the exercise for the offer price yields a similar pattern. Interestingly, we do not find any WR significantly above
one, which is consistent with our model, where firms only accept offer prices that are at least equal to fundamental value.
However, this result is difficult to reconcile with the view that IPO underpricing is a discount to fundamental value. This discount
would imply that investors who were allocated shares during the IPO would be better off investing in issuers than on their
matched firms, generating WRs above one. In fact, for high-underpricing periods we observe a WR of 0.72. This suggests that,
when investor sentiment is high, investors who are allocated IPO shares loose money if they hold on to these shares, consistent
with our model. The results are robust to using IPO-firms’ CARs, with matched firms as benchmark.
A potential concern with the above analysis is that WRs and matched-firm CARs fail to properly control for risk. Hence, our
results could be explained by issuers in high-underpricing periods being less risky. To address this concern, we examine several
post-IPO risk characteristics, including earnings volatility, delisting rates, total return volatility, and market beta. We find no
evidence that IPOs in periods of high underpricing periods are less risky than IPOs in low-underpricing periods. This suggests
that issuer risk cannot explain the long-term underperformance presented above.
We further run factor regressions to evaluate the risk-adjusted long-run performance. Specifically, for each month in high-
underpricing periods, we construct a portfolio that goes long in IPO firms and short in matched firms. We track the monthly
return of each long-short portfolio for five years. When the gap between two consecutive high-underpricing periods exceeds five
years, some months will have no returns. For every month with at least one return, we compute the average return of all overlap-
ping portfolios. This monthly average return is then regressed on a Fama–French–Carhart asset-pricing model, enhanced with a
liquidity factor. We repeat the procedure for low-underpricing periods. There is no evidence that IPO firms in low-underpricing
2
We cannot include IPOs that are more recent because we require five years of post-IPO return data to analyze IPO long-term performance.
F. Santos / Journal of Corporate Finance 42 (2017) 247–266 249
periods underperform in the long-run. However, for firms issuing in high-underpricing periods, our trading strategy yields a sta-
tistically marginally significant alpha of −0.53 % per month (p-value of 5.2%). This negative alpha, which is economically large,
is consistent with our model.
This paper contributes to the IPO literature in three ways. First, we offer an explanation for IPO market timing in the presence
of sentiment investors that explains why more firms go public as underpricing increases. Second, we add to the IPO long-term
performance literature. While other papers look at firm-specific underpricing, we focus on average market underpricing and
unravel a close relation to issuers’ long-run returns. Third, our results challenge the standard view that underpricing represents
a discount to fundamental value (Benveniste and Spindt, 1989; Benveniste and Wilhelm, 1990; Rock, 1986; Spatt and Srivastava,
1991; Welch, 1992) or a costly instrument that firms use to signal quality (Allen and Faulhaber, 1989; Chemmanur, 1993; Welch,
1989) .
The closest theoretical work to ours is Ljungqvist et al. (2006), who model a firm’s optimal IPO response to the presence of
sentiment investors and short-sale constraints. In their model, as in ours, firms raise IPO prices in order to exploit sentiment
investors’ overvaluations. However, firms cannot fully exploit sentiment investors and underpricing occurs as compensation
for inventory risk. We add an extra dimension by considering two types of firms with and without short-lived investment
opportunities, which allows us to develop predictions for the timing of the IPO decision.
Empirically, Pagano et al. (1998) show that firms are more likely to go public when the average market-to-book ratio of
public firms is high. Because these periods tend to follow and not precede periods of high investment, they conclude that firms
try to time their IPOs to take advantage of industry-wide overvaluations and not to finance their growth. Purnanandam and
Swaminathan (2001) value IPO firms using multiples from comparable public firms. Their results suggest that IPOs tend to be
sold at inflated prices as firms exploit excessively optimistic investors. Unlike these papers, we allow the motivation for the
going public decision to be time-variant. In periods of high underpricing, we also find that firms go public to take advantage
of overvaluations. However, in periods of low underpricing, we find that IPOs are motivated by growth opportunities and not
overpriced, refining the results of Pagano et al. (1998) and Purnanandam and Swaminathan (2001).
The outline of the paper is as follows: Section 2 presents the model while Section 3 describes the data, IPO underpricing cycle
and control firms. Section 4 presents the empirical results and Section 5 concludes the paper.
2. Model
This section introduces a model that predicts when different types of firms choose to go public. The model has two time
periods, t ∈ {I, II}. In Period I, firms may go public immediately or delay the IPO until Period II. As shown below, the main driver
of the timing decision is the expected demand from retail investors in the aftermarket.
2.1. Model setup
There are three parties to the model: firms, retail investors and intermediaries. The firm is run by an owner-manager, who
is rational, risk neutral and fully informed about firm value. Firm value Vt (F) is the sum of assets-in-place X and investment
opportunities. Firms are either Bad or Good, F ∈ {B, G}. Bad firms have no investment opportunities and are worth Vt (B) = X.
Good firms have positive net present value (NPV) projects that generate a cash-flow C at the end of Period I for an investment
K. With zero risk-free rate, the NPV of the project is C−K > 0. Investment opportunities are short-lived and can only be exercised
in Period I. If the firm delays the project, its competitors move first and the investment opportunity is gone. Firms do not have
internal funds to finance the project. The only way to fund the project is to sell shares in an IPO. Thus, a Good firm that goes
public in Period I is worth VI (G) = X + C − K. However, if it passes on the investment opportunity, it has a value of VII (G) = X in
Period II.3
For simplicity, the IPO process is modelled in two steps, s ∈ {1, 2}. In Step 1 (IPO), the firm receives offer prices from interme-
diaries. If the firm decides to go public, all shares are allocated to intermediaries.4 In Step 2 (aftermarket), retail investors may
appear and buy shares from the intermediaries.
We assume that retail investors are sentiment motivated and drive prices away from fundamental value, as in Ljungqvist
et al. (2006). Such price deviation could have several explanations. First, it could result from trading to exploit other sentiment
investors. Second, as in Baker and Wurgler (2006), retail investors may misvalue the firm, ignoring the information in other
investors’ trades. Third, as modelled by Welch (1992), the price deviation could be a “cascade” effect, where early investors
believe that the offering is a bargain and later investors ignore their own private information.
For retail investors to set the aftermarket price, we impose limits to arbitrage by not allowing short selling. The evidence in
Geczy et al. (2002) supports our short-selling constraint. They show that borrowing IPO shares in the early aftermarket tends to
be very expensive. Moreover, as shorting costs increase—effectively limiting short selling—so do the first-day returns.
3
Allowing for investment opportunities in Period II makes it more attractive in equilibrium for firms to postpone the IPO, but does not change the main
implications of the model otherwise.
4
For firms’ discretion on to whom allocate shares see, e.g., Benveniste and Spindt (1989) , Booth and Chua (1996) , Brennan and Franks (1997) , Mello and
Parsons (1998) , Stoughton and Zechner (1998) , Sherman (2000) , Sherman and Titman (2002) , and Loughran and Ritter (2002).
Following Ljungqvist et al. (2006), we assume that the demand from retail investors Dt,s is exogenous and can be low L or
high H. Below, we refer to the Step-1 and Step-2 retail investor demands (Dt,1 and Dt,2 ) as, respectively, pre-IPO demand and
aftermarket demand. When aftermarket demand is low (Dt,2 = L), retail investors do not appear. Intermediaries are therefore
unable to sell their IPO shares and keep them in inventory. If aftermarket demand is high (Dt,2 = H), retail investors buy all
newly issued shares from the intermediaries at a premium u > 0 to the offer price.
Firms and intermediaries know the pre-IPO demand. However, the retail demand may change between Step 1 and Step 2 of
the IPO process. Thus, when the firm decides to go public, there is still uncertainty about the aftermarket demand. This reflects
the typical lag of 4–6 months between the initial decision to go public and the first trading day, at which time market conditions
may have changed.
Let pH (Dt,1 ) be the Step-1 probability of high aftermarket demand (Dt,2 = H), where pH (H) = d and pH (L) = 1 − d. We assume
1
0.5 < d < 1+u and known to all agents, so the likelihood of high aftermarket demand is higher when pre-IPO demand Dt,1
is high rather than low. Without loss of generality, Period-II pre-IPO demand is set equal to the Period-I aftermarket demand
(DII,1 = DI,2 ).
Intermediaries are rational, risk neutral, fully informed about firm value and operate in a competitive market. This competi-
tion allows the firm to capture all potential rents from aftermarket trading with sentiment driven retail investors. For simplicity,
in our model, intermediaries include both underwriters and institutional investors. This is consistent with anecdotal evidence,
which suggests that underwriters and institutional investors cooperate in IPOs.5 One could model institutional investors sepa-
rately from underwriters. However, as long as the two groups have the same information, there is no price disagreement. Thus,
separating them only adds complexity to the model without affecting its implications.
2.2. The IPO process
In Step 1 of the IPO process, intermediaries offer to buy the firm’s shares, planning on reselling them to retail investors in
1
the aftermarket. With 0.5 < d < 1+u , there is always some probability of reselling the shares, exploiting sentiment investors’
high valuations. Furthermore, competition for the IPO drives any expected profits to the firm, forcing intermediaries to offer
Ot (F, Dt,1 ) > Vt (F). Because the expected aftermarket demand is higher when pre-IPO demand is also high, the offer price paid
by intermediaries increases with pre-IPO demand: Ot (F, H) > Ot (F, L).
In Step 2, if Dt,2 = H, intermediaries sell the shares at a premium u. However, if Dt,2 = L, intermediaries are unable to sell
and incur a loss Ot (F, Dt,1 ) − Vt (F) as the price ultimately in the future reverts to fundamental value. Hence, for intermediaries to
break-even:

[Vt (F) − Ot (F, Dt,1 )] × 1 − pH (Dt,1 ) + [Ot (F, Dt,1 ) × u] × pH (Dt,1 ) = 0. (1)
Solving for the offer price Ot yields:

Vt (F) × 1 − pH (Dt,1 )
Ot (F, Dt,1 ) = . (2)
1 − (1 + u) × pH (Dt,1 )
When aftermarket demand is high, the first-day closing price is Pt (F, H) = Ot (F, Dt,1 ) × (1 + u). When aftermarket demand
is low, there is no trade and the aftermarket price remains at the offer price Pt (F, L) = Ot (F, Dt,1 ). One could easily generate
a positive first-day return also when aftermarket demand is low by introducing a limited number of sentiment-driven retail
investors who pay a premium less than u.
Fig. 1 summarizes the timeline in our model and shows the corresponding firm value, retail investor demand, offer prices,
and aftermarket prices.
2.3. Equilibrium
For the owner-manager to sell the firm in an IPO, intermediaries have to offer a price that exceeds firm value, Ot (F, Dt,1 ) ≥
Vt (F). For the firm to go public in Period I, the offer price also has to exceed the expected offer price in Period II, OI (F, DI,1 ) ≥
E[OII (F, DII,1 )], or the firm will postpone the IPO. Combining the firm’s decision criteria with the intermediaries’ break-even price
(Eq. (2)) yields the following equilibrium in Period I (see Appendix A for proofs):
Proposition 1. When Period-I pre-IPO demand is high (DI,1 = H), all firms go public and offer prices are given by
X(1−d)
1−d(1+u)
if F = B
OI (F, H) = (X+C−K)(1−d)
(3)
1−d(1+u)
if F = G.
5
“CSFB [Credit Suisse First Boston Corporation] allocated shares of IPOs to more than 100 customers who, in return, funneled between 33 and 65% of their
IPO profits to CSFB. These customers typically flipped the stock on the day of the IPO, often gaining tremendous profits.” (SEC News Release 2002-14). See also
Cornelli and Goldreich (2001) for favorable allocations to recurring institutional investors.
Fig. 1. Model timeline.
When pre-IPO demand is high, both Good and Bad firms go public in Period I. The intuition is that the expected probability
of high aftermarket demand in Period II (a blend of d and 1 − d) can never exceed the current probability d. Hence, the Period-I
offer price always exceeds the expected Period-II offer price, and firms have no incentive to delay the IPO.6
Proposition 2. When Period-I pre-IPO demand is low (DI,1 = L), Bad firms postpone the IPO decision. Good firms go public in Period
I if and only if C − K ≥ kX, wherek = −u(1−d)(1−2d)
d[1−d(1+u)]
, and the offer price is given by
(X + C − K)d
OI (G, L) = . (4)
1 − (1 − d)(1 + u)
When pre-IPO demand is low, Bad firms are better off delaying the IPO. Using the same intuition as above, the expected
Period-II probability of high aftermarket demand (again a blend of d and 1 − d) is higher than the current probability 1 − d. As a
result, the expected Period-II offer price exceeds the Period-I offer price, and Bad firms postpone the IPO.
For Good firms, recall that investment opportunities are short-lived and only exist in Period I. Thus, Good firms face a tradeoff
between a higher expected Period-II aftermarket demand and the benefit of exploiting the investment opportunity in Period I.
Xd
With probability d, the Period-II pre-IPO demand remains low and the offer price is OII (G, L) = 1−(1−d)(1+u) . In this case, firms
cannot further exploit retail investors as pre-IPO demand in Period II remains the same. Because the investment opportunity is
lost if waiting, the Period-II offer price will then be lower than the current offer OI (G, L). However, with probability 1 − d, the
X(1−d)
Period-II pre-IPO demand switches to high and the offer price is OII (G, H) = 1−d(1+u) . Depending on the parameter values of
C − K, d, and u, this may or may not exceed the Period-I offer price OI (G, L).
If C − K ≥ kX, the expected Period-II offer price exceeds OI (G, L) and Good firms go public in Period I. On the other hand, if
C − K < kX, then E[OII (G, DII,1 )] < OI (G, L) and Good firms are better off postponing the IPO.
Propositions 1 and 2 show that firms time and price their IPO depending on the sentiment of the market. We next explore
this implication in the empirical analysis below.
2.4. Empirical predictions
Our theoretical model suggests that the timing and price of the IPO depend on both market sentiment and firm quality. Bad
firms, lacking positive NPV investment opportunities, only go public to exploit exuberant retail investors. While good firms also
want to take advantage of temporary market overvaluations, they have profitable investment projects that sometimes cannot
wait. As a result, these high-quality firms may go public even when investor sentiment is low. This generates our first testable
empirical prediction.
Hypothesis 1 (H1). When retail demand is low, only high-quality firms with valuable investment opportunities go public. When
retail demand is high, all types of firms go public, implying lower average quality of their investments.
Pagano et al. (1998) find support that firms try to time their IPOs so they can take advantage of industry-wide overvaluations,
rather than to finance their growth. Based on a sample of Italian firms, and using both ex-ante and ex-post information on
characteristics and performance, they find that firms are more likely to go public when the average market-to-book ratio of
6
In our model, there are no benefits of remaining private, e.g. benefits to the owner-manager from controlling the firm. In reality, these benefits can be large
and explain why we do not observe all private firms going public in periods of high pre-IPO demand.
public firms is high. Moreover, they find that higher market-to-book ratios do not reflect investment opportunities as companies
tend do go public after and not before periods of high investment.
Purnanandam and Swaminathan (2001) use intrinsic value based on industry-matched price/sales and price/EBITDA from
comparable public firms and find that offer prices are priced 50% above comparables. They interpret this premium as an attempt
by firms to exploit excessively optimistic investors.
The model also provides predictions about offer and aftermarket prices. Offer prices reflect the extent to which firms ex-ante
are able to exploit sentiment-driven investors. Aftermarket prices reflect the ex-post level of retail investor demand. First, all
IPO firms set offer prices above fundamental value anticipating the presence of sentiment-driven investors in the aftermarket.
The higher the retail demand, the greater the wedge between the offer price and firm value. Second, when aftermarket demand
is high, first-day returns will be high, further increasing the deviation in price from firm value. This leads to our second empirical
prediction.
Hypothesis 2 (H2). IPOs in periods of high retail demand are priced and trade substantially above fundamental value, and therefore
underperform in the long run.
Ritter (1991), Loughran and Ritter (1995) provide evidence that IPO firms tend to underperform in the long-run compared
to the market and a set of comparable firms matched by industry and size. However, Brav and Gompers (1997) argue that the
underperformance effect is considerably more complicated as they find it is concentrated in small firms that are not backed by
venture capitalists. Moreover, they argue that the underperformance does not stem from the issuer being an IPO but from the
fact these are high market-to-book stocks.
Ritter and Welch (2002) show that IPO firms with larger revenues display better performance. Our model provides an expla-
nation for such. Low-quality firms, lacking investment opportunities, are not able to generate large revenues. These issuers time
the market and only go public in periods of high underpricing, underperforming in the long run. High-quality firms, in the con-
trary, do not time their IPOs to market conditions. Thus, some of these firms go public in periods of low retail demand, with no
long-term underperformance and large revenues.
Although the discussion on the issue is still open, some explanations have been proposed to why IPO firms perform poorly
in the long run: continued risk mismeasurement, simple bad luck or fads. For example, Shiller (1989) suggest a fad story where
investors get excited about high initial returns, ending up overvaluing these issues. In Shiller (1989), as in many others papers
(for references see Ritter and Welch, 2002), firms perform poorly in the long-run relative to the first-trading day closing price.
Our model goes one step further by predicting that, in certain periods, even offer prices are overvalued and generate poor
long-term performance.
3. Sample selection, retail demand and control firms
3.1. Sample selection and issue characteristics
We first select all US IPOs completed between January 1, 1973 and December 31, 2009 from Thomson SDC Platinum. We
cannot include IPOs that are more recent because we require five years of post-IPO return data to analyze IPO long-term perfor-
mance. Moreover, we exclude unit offers, spin-offs, closed-end funds, IPOs with an offer price below $1, Real Estate Investments
Trusts (REITs), American Deposit Receipts (ADRs) and financial firms as described by SDC. This yields a total of 6858 IPOs, for
which we obtain the offer price, date of issue and the dollar value of proceeds.
Based on the Cusip reported by SDC, we match the IPOs with Center for Research in Security Prices (CRSP) to obtain stock
prices. We require prices in CRSP to start sometime between the SDC issue date and three trading days later. This matching
procedure eliminates 586 cases, leaving the sample with 6272 IPOs. In subsequent sections, the number of observations is
further reduced due to unavailability of data to compute the necessary variables.
Table 1 shows the distribution and issue characteristics of the IPOs across the sample period. The table lists the annual
number of IPOs, average first-day returns, average and aggregate proceeds, and average and aggregate money “left on the table”
(proceeds times first-day return). The number of IPOs fluctuates substantially over time, with the highest IPO activity in the
second half of the 1990s. There is also large variation in the average first-day returns, ranging from 1.9% in 1974 to 78.6% in
1999. Note that the annual average first-day return is always positive, consistent with persistence in IPO underpricing. See, e.g.,
Reilly (1973), Ibbotson (1975), Ritter and Welch (2002), and Loughran and Ritter (2002).
Interestingly, high IPO activity tends to coincide with high underpricing. Lowry and William Schwert (2002) note that IPO
volume tends to go up after periods of high returns. This timing of issuing activity is puzzling, since high underpricing implies
that firms leave large amounts for investors in the aftermarket. In 1999 and 2000 alone, the combination of high IPO activity and
high first-day returns resulted in $59 billion left on the table. This represents almost 90% of the total proceeds raised in these
two years.
Table 1
Distribution and issue characteristics of IPOs in the U.S. from 1973 to 2009.
Cohort year Number of IPOs Average 1st day return Average proceeds Aggregate proceeds Average money left Aggregate money left
on the table on the table
1973 5 25.2% 7.8 39 1.9 9.7

1974 2 1.9% 8.1 16.1 0.1 0.3
1975 4 8.7% 12.3 49.2 0.6 2.6
1976 23 2.7% 8.3 191.7 0.2 4.1
1977 13 11.8% 7.9 102.8 0.5 6.4
1978 17 21.5% 8.3 140.7 1.1 19.1
1979 34 12.7% 7.5 254.9 1.0 32.8
1980 58 27.3% 11.7 680.8 3.0 175.7
1981 159 9.9% 10.3 1643.4 0.8 129.0
1982 51 12.4% 13.3 679.6 2.0 102.4
1983 306 13.4% 17.7 5411 2.1 645.6
1984 131 4.5% 9.0 1172.8 0.4 47.4
1985 139 10.0% 13.9 1938.6 0.9 123.8
1986 333 8.8% 28.5 9503 2.4 791.7
1987 267 8.9% 24.1 6443 2.7 733.7
1988 99 8.8% 27.5 2722.8 1.6 161.0
1989 103 17.1% 37.1 3824.6 17.9 1841.2
1990 108 11.7% 27.8 3004.7 4.4 475.8
1991 241 13.4% 37.2 8974 5.5 1331.1
1992 315 10.6% 40.4 12,725.4 3.9 1214.8
1993 408 14.5% 41.6 16,982.9 5.8 2348.1
1994 346 10.2% 36.3 12,563.7 4.0 1380.4
1995 412 23.1% 48.4 19,942.1 11.0 4511.7
1996 591 16.8% 46.7 27,570.7 8.0 4726.6
1997 410 15.9% 52.7 21,590.9 7.4 3016.9
1998 231 23.3% 55.3 12,776.9 11.9 2738.6
1999 397 78.6% 97.1 38,546.4 80.2 31,826.0
2000 313 56.7% 100.0 31,299.2 67.0 20,985.8
2001 59 17.4% 114.7 6765.2 19.2 1130.5
2002 56 8.7% 130.8 7323.7 13.2 739.2
2003 52 12.5% 134.2 6979.1 12.6 655.2
2004 146 11.8% 137.7 20,098 22.0 3217.8
2005 132 9.7% 161.8 21,359.8 12.9 1696.4
2006 137 10.5% 171.5 23,501.3 18.2 2500.2
2007 137 12.5% 157.9 21,634 20.7 2841.0
2008 21 4.9% 244.1 5127.1 26.8 562.5
2009 14 26.7% 253.4 3547.8 65.3 913.8
Average 165.1 20.0% 57.0 9404.1 14.9 2460.0
The sample is composed by U.S. IPOs completed between August 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
spin-offs, closed-end funds, IPOs with an offer price below $1.00, Real Estate Investments Trusts (REITS) and financial firms as described by SDC are excluded
from our sample. Values in million of dollars and not inflation adjusted. Money left on the table is computed as first day return times number of shares issued.
In models where underpricing is a discount to fundamental value, such timing of issuing activity to high underpricing periods
is largely irrational.7 However, if underpricing reflects retail demand, this timing is rational and consistent with our model.
First, it allows firms to exploit sentiment-driven investors by going public in periods when offer prices are set above firm value.
Second, the money left on the table is necessary to compensate intermediaries for ex-ante inventory risk. We next turn to
establishing the critical link between retail demand and underpricing.
3.2. Retail demand and underpricing
In the model, firms and intermediaries know if sentiment-driven retail investors are present in the market. However, in real-
ity, there is no publicly available data on IPO allocations or investor-identity in the aftermarket. Thus, in order to test the model,
we need a measure for retail demand. As argued below, we use IPO first-day returns, where high retail demand corresponds to
high underpricing and vice versa.
There are several reasons why IPO underpricing is a good proxy for investor sentiment. First, recall that in our model, under-
pricing is perfectly correlated with the level of retail demand: when demand is high, retail investors pay a premium to the offer
price; when demand is low, aftermarket prices equal offer prices.
Second, as pointed out by Baker and Wurgler (2006) p.1656, “The IPO market is often viewed as sensitive to sentiment, and
high-first day returns on IPOs may also be a measure of investor enthusiasm”. More importantly, they show that IPO underpric-
ing predicts the cross-section of stock returns over the next year. When average underpricing in the market is high (low), the
returns of firms more likely to be affected by sentiment tend to be relatively low (high).
7
An exception is Alti (2005), where information cascades generate a correlation between issuing activity and underpricing.
Based on this empirical link, we construct an IPO underpricing cycle. For every month in our sample, we compute the
equally-weighted average underpricing (Market underpricing ). We then compare each monthly underpricing with the sample
distribution of Market underpricing . A month is classified as high underpricing (High month ) if it is in the top quartile (above 19%)
and low (Low month ) otherwise. As reported in Panel A of Table 2, 109 months (24.9%) are categorized as high underpricing,
with the remainder 328 months (75.1%) being classified as low underpricing.
Given that the process of going public typically takes 3–4 months, an IPO in a high-underpricing month might have been initi-
ated when market conditions were unfavorable. In such cases, issuers are not motivated by sentiment investors’ overvaluations
because their presence in the aftermarket was not expected. To address this issue, we cluster months into periods of high and
low underpricing. High-underpricing periods (High) consist of all periods with more than four consecutive high-underpricing
months, excluding the first four months (First-four ). The First-four are not classified as High because IPOs in these months are
initiated when underpricing is low. All months not included in High are categorized as low-underpricing periods (Low). As a
robustness, we create Only low where we exclude First-four . As an example, from November 1982 to June 1983 we have eight
high-underpricing months. The last four months are classified as High. The first four months are included in Low but not in Only
low .
Panel B of Table 2 reports descriptive statistics on our IPO cycle. There are 5 high-underpricing periods, with an average
length of 9.2 months (median 5 months). The longest high-underpricing period is 24 months, ranging from February 1999
through January 2001. There are 6 low-underpricing periods, with an average (median) length of 65.2 (45.5). In Panel C, we
present the robustness classification where low-underpricing periods do not include First-four .
Table 2 also shows the number of IPOs and average first-day returns by underpricing month (Panel A), underpricing period
(Panel B), and for the robustness classification (Panel C). There are 4903 IPOs (78.2% of the sample) in low-underpricing periods,
with an average first-day return of 14%. Only 10.8% of the sample months are classified as high-underpricing, but, due to the
intense IPO activity in these periods, this corresponds to 21.8% of all IPOs with an average first-day return of 44.8%.
Carter and Manaster (1990), Beatty and Welch (1996), Cooney et al. (2001), and others have documented a relation between
underwriter prestige and underpricing. For that reason, in the last column of Table 2 we present average lead underwriter rep-
utation, measured by the Carter and Manaster ranking. This is a 9-point scale, where higher ranks represent higher underwriter
prestige. Rankings are available for 1980 to 2010 and are based on Loughran and Ritter (2004) and subsequent updates from the
authors. As seen in Panel A, the average reputation for lead underwriters of IPOs in low-underpricing months is higher than in
high-underpricing months (7.42 vs. 6.37). Considering underpricing period (Panel B) or the robustness classification (Panel C)
does not affect significantly this difference.
Obviously, our model cannot generate any predictions on the choice of underwriter. However, it is not surprising that the
quality of the issuers’ investments correlates positively with the prestige of the investment bank hired. First, high-quality firms
hire underwriters that can better evaluate their investment projects and in a time when market timing is not the major concern.
Second, hiring prestigious underwriters can signal that the firm has indeed profitable investment opportunities. As Carter and
Manaster (1990) argue, IPOs taken public by prestigious underwriters benefit from superior certification.
To verify that our IPO underpricing periods represent periods of high retail demand, we examine investors’ aftermarket
trading. When investor sentiment is high, the trading patterns should reflect the enthusiasm of retail investors. Thus, we expect
a relatively high fraction of the firm’s shares to be traded in the aftermarket, predominantly through small trades.
Table 3 reports the coefficient estimates from ordinary least squares (OLS) regressions of turnover (measured as volume over
shares outstanding) and number of trades on the first trading day. In Panel A, the explanatory variable is High with Low as the
baseline. As shown in the table, IPOs in low-underpricing periods have an average turnover of 15% and 2210 first-day trades.
Table 2
IPO underpricing cycle statistics.
# % Months in # Period length (in months) # IPOs % IPOs in First-day Underwriter

Months the sample Periods the sample return reputation
Average Median Min Max
Panel A — Full sample divided by months

Low month 328 75.1% 4248 67.7% 8.4% 7.42
High month 109 24.9% 2024 32.3% 41.5% 6.37
Panel B — Full sample divided by periods

Low 390 89.2% 6 65.2 45.5 25 143 4903 78.2% 14.0% 7.68
High 47 10.8% 5 9.2 5 2 24 1369 21.8% 44.8% 6.29
Panel C — Robustness classification

Only low 356 81.5% 6 61.2 41.8 21 139 4431 70.6% 12.8% 7.71
First-four 34 7.8% 5 4 4 4 4 472 7.5% 46.0% 7.48
The sample is composed by U.S. IPOs completed between August 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers, spin-
offs, closed-end funds, IPOs with an offer price below $1.00, Real Estate Investments Trusts (REITS) and financial firms as described by SDC are excluded from
our sample. For every month in our sample, we compute the equally-weighted average underpricing and compare it with the average monthly underpricing
in the sample. A month is classified as high underpricing (High month) if it is in the top quartile, and low (Low month) otherwise. High-underpricing periods
(High) consist of all periods with more than four consecutive high-underpricing months, excluding the first four months (First-four). All months not included in
High are classified as low-underpricing periods (Low). Excluding First-four months from Low delivers Only low periods. Underwriter reputation is defined as the
Carter and Manaster (1990) 9-point ranking, with 9 being the highest prestige.
Table 3
First trading day measures of IPO firms as a function of IPO underpricing cycle.
Turnover Number of trades
Panel A — Regression results with “Low” as baseline.

Constant 15.48%*** 2210.83***
72.93 22.3
High 8.65*** 6484.32***
15.24 16.75
n 4557 3088
R2 0.056 0.090
Panel B — Regression results with “Only low” as baseline.

Constant 15.06%*** 2212.88***
69.03*** 20.61***
First-four 4.14%*** −15.41
5.14 −0.06
High 9.07%*** 6482.27***
15.92 16.65
n 4557 3088
R2 0.062 0.105
High — First-four 3.93%*** 6497.68***
Wald test 132.83 140.32
The sample is composed by U.S. IPOs completed between August 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
from our sample. Dependent variables are turnover (percentage of total shares transacted on the first trading day) and number of trades. Panel A explanatory
variable is High, with Low as baseline. Panel B adds First-four, with Only low as baseline. High-underpricing periods (High) consist of all periods with more than
four consecutive high-underpricing months, excluding the first four months (First-four). All months not included in High are classified as low-underpricing
periods (Low). Excluding First-four months from Low delivers Only low periods. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
The coefficient on High is positive and highly significant in both regressions: nine percentage points in turnover and 6484 in
trades. Compared to low-underpricing periods, this represents an increase of 56% in turnover and almost 300% in the number
of trades, consistent with a relatively high presence of retail investors. As a robustness, in Panel B of Table 3, the baseline is Only
low , while First-four and High enter separately. Comparing Only low with High we obtain very similar results as in Panel A.8
Another way to validate the link between investor sentiment and IPO underpricing periods is through investors’ reaction
to earnings announcements. We therefore examine if, due to their increased optimism, investors react more favorably to new
information in periods of high sentiment.
From Institutional Brokers’ Estimate System (I/B/E/S) and Compustat, we obtain quarterly earnings announcement dates
from January 1, 1984 to December 31, 2009 for all U.S. public firms. We cannot match the entire IPO-sample period because
earnings announcements from 1973 to 1983 are not available. Following Kothari (2001), we compute earnings surprises as the
difference between the median analysts forecast on I/B/E/S and actual reported earnings, normalized by the price observed
seven business days prior to the announcement date. As in DellaVigna and Pollet (2009), we sort all earnings surprises into
eleven quantiles, constructed year by year. Quantiles 1 to 5 contain negative surprises, while positive surprises are sorted into
quantiles 7 to 11. Announcements where analysts perfectly forecasted earnings are included in quantile 6. Then, for each firm-
quarter observation, we compute CAR0,1 — the two-day (announcement day and next business day) cumulative abnormal return
in excess of the value-weighted market index.9
For each surprise quantile and for each quarter, we construct an equally-weighted average CAR0,1 . We then split the sam-
ple into announcements in high-underpricing periods and announcements in low-underpricing periods. Fig. 2 plots the average
CAR0,1 for both subsamples. It shows that investors, during periods of high underpricing, react more favorably to earnings
announcements. The average CAR0,1 is higher in the high-underpricing sample for all quantiles and the effect is particularly
strong when analysts underestimate earnings. For quantile 11, average CAR0,1 in the low-underpricing subsample is 2.14%, while
it is 3.18% for high-underpricing periods — one percentage point difference in a two-day window.
We further perform OLS regressions of each CAR0,1 on the level of underpricing at the time of the announcement. Results
of the different specifications are presented in Table 4 and support the view that investors react more favorably to earnings in
periods of high underpricing.
In column (1), the explanatory variables are High, earnings surprise and an interaction term. Naturally, higher surprises
in earnings leads to higher CAR0,1 . More interestingly, the coefficient on High is positive and highly significant — earnings
announced in high-underpricing periods yield an additional CAR0,1 of 49 basis points (bps). In column (2), we add the firm’s
decile of market capitalization and of book-to-market, year and month as controls. The coefficient on High remains unchanged
at 49 bps. To control for potential non-linearities in CAR0,1 , we add dummies for the extreme surprise quantiles: the bottom
and top quantile in column (3), and the bottom two and top two quantiles in column (4). Importantly, the significance and
magnitude of the coefficient on High remains unchanged. Furthermore, earnings surprises generate an extra 54 bps in CAR0,1 in
8
The results do not change if we use underpricing months or measure turnover and number of trades over the first 5 or 10 trading days.
9
See Appendix B for a fully detailed description on the construction of earnings announcement dates, earnings surprises and CAR0,1 .
Fig. 2. Earnings announcement two-day CAR as a function of IPO underpricing cycle. The sample is composed by 175,384 observations. Each observation
corresponds to quarterly announcements in I/B/E/S from January 1984 to December 2009 for which there is information on the firm in Compustat and on the
stock in CRSP. Earnings surprises are computed as the difference between median analysts forecast on I/B/E/S and reported earnings scaled by the price one
week prior to the announcement date. Quantiles 1 to 5 contain negative surprises; quantile 6 has all announcements with no surprises; and quantiles 7 to 11
contain positive surprises. Quantiles are constructed year by year. Cumulative abnormal returns are raw buy-and-hold returns for the day of announcement and
the next one, adjusted by the market model beta. High-underpricing periods (High) consist of all periods with more than four consecutive high-underpricing
months, excluding the first four months (First-four). All months not included in High are classified as low-underpricing periods (Low).
the top quantile during high-underpricing periods and an extra 25 bps across the top two quantiles. These results suggest that
investors react more positively to news in high underpricing periods, and more so to good news.
Note that, in this test, we use information on all publicly listed firms and not only IPO firms. This is a more demanding setting
because, in the absence of any clear limits to arbitrage, it is difficult for prices to be affected by sentiment-driven investors.
Nevertheless, the results in Table 4 show that prices are affected more by news in periods of high-sentiment. More importantly,
combined with the evidence in Table 3, we show that investor sentiment and IPO underpricing are indeed closely related. Hence,
to test our empirical predictions we only need to find a proper benchmark for IPO firms. This is discussed in the next section.
3.3. Control firms
To obtain control firms for our sample of IPO firms, we follow Lie (2001) and match the IPO firms with public firms with
similar characteristics at the time of the IPO.10 The matching criteria are book value of assets, market capitalization, return on
assets (ROA), and industry.
For each IPO firm, we obtain control firms from the universe of firms on Compustat. Specifically, we define three criteria: (I)
same three-digit SIC code; market size, ROA, and book value of assets between 70% and 130% of the IPO firm values; (II) same as
(I) except for matching on two-digit SIC code; and (III) same as (II) but with bands on market size, ROA, and book value of assets
enlarged to 50% and 150%. We do not include control firms whose IPOs are less than five years prior to the IPO of the sample
firm. We apply criteria (I) and choose the five firms closest to the IPO firm in terms of market size. If criteria (I) does not yield
five control firms, we then apply criteria (II) for additional control firms. If (I) and (II) together fail to provide five control firms
for each IPO firm, we apply criteria (III). In the end, for each IPO firm, we obtain a portfolio of five control firms as benchmark.11
Table 5 provides statistics on the quality of the matching procedure. From Panel A, we see that, for the entire sample, there
are no significant differences between the sample of issuers and the control group. Most importantly, looking at Panels B and C,
we observe that the quality of the matching procedure is not a function of underpricing periods.
10
Due to lack of information prior to the IPO, we can only measure IPO firms’ characteristics at the end of the first fiscal year after the IPO.
11
Choosing the set of firms obtained using only criteria (I) or only the closest firm does not change the results below. Using book-to-market instead of market
size, or doing a propensity score matching also do not affect the results qualitatively.
Table 4
Earnings announcement two-day CAR as a function of IPO underpricing cycle.
(1) (2) (3) (4)
Constant 0.0010*** 0.0025 0.0035 0.0043*

3.13 1.13 1.59 1.94
High 0.0049*** 0.0049*** 0 .0047*** 0.0048***
6.75 4.12 3.98 3.96
Earnings surprise 0.1801*** 0.2159
11.12 1.39
High*Earnings surprise −0.0047 0.0016
−0.15 0.03
Bottom quantile −0.0217***
−21.12
Top quantile 0.0211***
26.21
High*Bottom quantile −0.0035
−1.63
High*Top quantile 0.0054***
2.93
Bottom two quantiles −0.0199***
−27.92
Top two quantiles 0.0186***
34.91
High*Bottom two quantiles −0.0024*
−1.75
High*Top two quantiles 0.0025**
1.97
Controls No Yes Yes Yes
n 175,384 175,384 175,384 175,384
R2 0.007 0.015 0.025 0.035
The sample is composed by quarterly earnings announcements as observed on I/B/E/S from January 1984 to December 2009, for which there is information
on the firm in Compustat and on the share price in CRSP. The dependent variable is the two-day CAR defined as the buy-and-hold return for the day of
announcement and the next one, adjusted by the market model beta. High-underpricing periods (High) consist of all periods with more than four consecutive
high-underpricing months, excluding the first four months (First-four). Earnings surprises are computed as the difference between median analysts forecast on
I/B/E/S and reported earnings scaled by the price one week prior to the announcement date. Earning surprises are sorted into 11 quantiles. Quantiles 1 to 5
contain negative surprises; quantile 6 has all announcements with no surprises; and quantiles 7 to 11 contain positive surprises. Quantiles are constructed year
by year. Bottom quantile and Bottom two quantiles are dummy variables equal to one if the earnings surprise is in quantile 1 or quantiles 1 and 2, respectively.
Top quantile and Top two quantiles are dummy variables equal to one if the earnings surprise is in quantile 11 or quantiles 10 and 11, respectively. Controls
include decile of market capitalization, decile of book to market, year and month of the announcement. Standard errors are White corrected and clustered by
date of announcement. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
4. Empirical analysis
In this section, we test the two empirical predictions of our model using our IPO underpricing cycle as a proxy for retail
demand.
4.1. Issuers’ investment quality across the IPO underpricing cycle
Recall that H1 states only high-quality firms with valuable investment opportunities go public, when underpricing is low,
while all types of firms go public, when underpricing is high, implying lower average quality of the latter firms’ investments. To
test this hypothesis, we examine post-IPO investment and performance of IPO firms relative to their peers. Specifically, we focus
on post-IPO ROA and investment rates.12 ROA is defined as operating income before depreciation (EBITDA) over total assets
and investment rate is capital expenditure (CAPEX) over total assets. Using data from Compustat, we compute peer-adjusted
measures as the difference between the issuer and the average of its control firms.
Panel A of Table 6 presents statistics on ROA and investment rates one year after the IPO for IPO firms, their peers and the
difference between them. The results are consistent with H1. Issuers in low-underpricing periods (Low) display higher operating
profitability (9% vs. 7%) and higher investment rate (13% vs. 9%) than their peers. The pattern for firms going public in high-
underpricing periods (High) is different, however. These issuers display comparable investment rates as their matched firms, but
become significantly less profitable (−4 % vs. 5%). Since ROA was one of the criteria used in the matching process, it appears that
the quality of investment opportunities fall after the IPO for issuers in high-underpricing periods, consistent with our model. As
a robustness test, we look at IPOs in Only low and find almost identical results. Moreover, IPOs in First-four also become more
profitable and invest more than their peers. Although these issues happen in high underpricing months, they were initiated
when underpricing was low. Hence, this higher quality of their investments is expected.
12
Similar qualitative results are obtained with total assets or sales growth.
Table 5
Statistics on the IPO matching procedure.
IPOs Peers Diff. t-stat
Panel A — Entire sample

Book value of assets 228.07 231.22 −3.15 −0.88
Market capitalization 426.94 420.75 6.19 1.3
ROA 3.48% 3.87% −0.39% −1.23
Panel B — Low
Book value of assets 257.23 255.21 2.02 0.91
ROA 6.05% 5.85% 0.20% 0.53
Panel C — High
Book value of assets 230.62 232.68 −2.08 −0.53
ROA −2.53% −2.33% −0.20% −0.62
The IPO sample is composed by U.S. IPOs completed between August 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
from our sample. For each IPO firm, we obtain control firms from the universe of firms on Compustat. Specifically, we define three criteria: (I) same three-digit
SIC code; market size, ROA, and book value of assets between 70% and 130% of the IPO firm values; (II) same as (I) except for matching on two-digit SIC code;
and (III) same as (II) but with bands on market size, ROA, and book value of assets enlarged to 50% and 150%. We do not include control firms whose IPOs are
less than five years prior to the IPO of the sample firm. We apply criteria (I) and choose the five firms closest to the IPO firm in terms of market size. If criteria
(I) does not yield five control firms, we then apply criteria (II) for additional control firms. If (I) and (II) together fail to provide five control firms for each IPO
firm, we apply criteria (III). In the end, for each IPO firm, we obtain a portfolio of five control firms as benchmark. High-underpricing periods (High) consist of all
periods with more than four consecutive high-underpricing months, excluding the first four months (First-four). All months not included in High are classified
as low-underpricing periods (Low). ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
Next, we test if the difference between issuers and their peers vary across the IPO underpricing cycle. Panel B of Table 6
reports the results from OLS regressions of the peer-adjusted measures on the dummy variable High, with Low as the baseline.
As expected, the coefficient estimates for High are significantly negative, confirming the differences in peer-adjusted ROA and
investment rate between low- and high-underpricing issuers. In Panel C, we use our robustness classification where the baseline
is Only low and First-four and High are the explanatory variables. Results are consistent with Panel B as the coefficient estimates
on High are almost identical. Moreover, issuers’ investment quality in First-four is the same as in Only low and significantly
higher than in high-underpricing periods.
It might be that any effects on investment rates and ROA for issuers in high-underpricing just take longer to materialize. We
address this issue in Panels D–F where we repeat the analysis looking at three-year post-IPO measures. We do not find strik-
ing differences to the one-year results. Interestingly, issuers in low-underpricing periods improve their operating profitability
advantage relative to their peers over the three-year period (18% vs. 12%). Firms going public in high-underpricing still display
lower ROA than their peers but the difference is lower (7% vs. 10%). Nonetheless, differences between issuers and their peers
still vary in the same magnitude across the IPO underpricing cycle.
As an additional robustness test, Table 7 presents additional OLS regressions that do not depend on our underpricing period
classification. The dependent variables are the differences in ROA and investment rates, one and three years after the IPO,
between issuers and their matched firms. In columns (1), (4), (7) and (10), the independent variables are firm’s underpricing and
the equally-weighted average underpricing in the market (Market underpricing ) the month prior to the IPO. We expect a neg-
ative relation between Market underpricing and issuer investment quality because higher underpricing in the market increases
the likelihood of an IPO due to sentiment-driven investors’ overvaluations. Supporting H1, we find that Market underpricing
generates a significant and negative coefficient.
Due to potential non-linearities in Market underpricing , in columns (2), (5), (8) and (10) we use a High month dummy, with
Low month as the baseline. As expected and consistent with Table 6, we find, from the constant coefficient, that firms issuing after
a month of low underpricing display higher ROA and investment rates than their peers. The coefficient estimates on High are not
significant except for the one-year post-IPO ROA. This might be because many of the IPOs in these high-underpricing months
were initiated when underpricing was low. Therefore, in columns (3), (6), (9) and (12), we include the number of consecutive
high and underpricing months prior to the IPO. Consistent with our model, Num high months is significant and negative for all
measures, implying that firms going public after several months of high underpricing display significantly worse peer-adjusted
ROA and investment rates.
Overall, the results suggest that issuers in low-underpricing periods use the proceeds to exercise profitable investment
opportunities, while issuers in high-underpricing periods lack profitable projects, as predicted in H1.
4.2. Issuers’ long-run performance across the IPO underpricing cycle
Recall that according to H2, IPOs in periods of high underpricing are priced and trade substantially above fundamental value,
and therefore underperform in the long run. To test H2, we first examine wealth ratios defined as the value from investing in
IPO firms relative to their peers. We use daily and monthly returns from CRSP to compute five-year buy-and-hold returns for
Table 6
Post-IPO ROA and investment rates as a function of IPO underpricing cycle.
One year after the IPO
ROA Investment rate
n IPOs Peers Diff. t-Stat n IPOs Peers Diff. t-Stat
Panel A — Average across periods.

High 905 −4.4% 4.8% −9.1%*** −7.99 898 10.9% 9.2% 1.7% 0.85
Low 3618 8.6% 6.8% 1.8%*** 3.50 3582 13.5% 8.6% 4.8%*** 15.45
Only low 3262 8.6% 6.8% 1.7%*** 3.27 3231 13.4% 8.6% 4.8%*** 14.53
First-four 356 8.5% 6.5% 1.9%** 2.05 351 13.8% 8.4% 5.4%*** 5.25
Panel B — Regression results with “Low” as baseline.

Constant 1.75*** 3.50 4.84*** 15.45
High −10.89*** −8.73 −3.12*** −3.07
n 4523 4480
R2 0.0197 0.0071
Panel C — Regression results with “Only low” as baseline.

Constant 1.73*** 3.27 4.78*** 14.53
First-four 0.21 0.13 0.60 0.55
High −10.87*** −8.63 −3.06*** −2.95
n 4523 4480
R2 0.0194 0.0073
High — First-four −11.08*** −3.66***
Wald test 38.09 4.84
Three years after the IPO
ROA Investment rate
n IPOs Peers Diff. t-Stat n IPOs Peers Diff. t-Stat

Panel D — Average across periods.
High 654 7.3% 10.2% −2.9%** −2.03 647 11.0% 9.8% 1.2% 1.38
Low 2712 18.0% 12.2% 5.8%*** 6.17 2666 17.4% 12.1% 5.3%*** 8.95
Only low 2480 18.8% 12.6% 6.2%*** 6.36 2437 17.5% 12.1% 5.4%*** 8.75
First-four 232 11.0% 7.8% 3.1%** 2.15 229 15.5% 10.9% 4.6%** 1.99
Panel E — Regression results with “Low” as baseline.

Constant 5.78*** 6.17 5.26*** 8.95
High −8.69*** −4.05 −4.04*** −3.82
n 3336 3313
R2 0.0091 0.0051
Panel F — Regression results with “Only low” as baseline.

Constant 6.22*** 6.36 5.42*** 8.75
First-four −3.10* −1.85 −0.82 −0.92
High −9.12*** −4.23 −4.21*** −3.90
n 3336 3313
R2 0.0096 0.0053
High — First-four −6.02*** −3.39***
Wald test 9.31 7.64
The sample is composed by U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
from our sample. In Panel A, we compare one-year post-IPO ROA and investment rates of IPO firms with a portfolio of five public matched firms. In Panel B, we
regress the peer-adjusted performance measures onto High, with Low as baseline. In Panel C, the baseline is Only low with First-four and High as explanatory
variables. Panels D–F repeat the exercise using three-year post IPO measures. Peer-adjusted performance measures are Winsorized at the 1% level. High-
underpricing periods (High) consist of all periods with more than four consecutive high-underpricing months, excluding the first four months (First-four). All
months not included in High are classified as low-underpricing periods (Low). Excluding First-four months from Low delivers Only low periods. T-stats based on
White corrected and period-clustered standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
5 5
each IPO firm rIPO and its portfolio of control firms rControl . We require that IPO firms have at least one year of return-history
5
1+rIPO
after the IPO.13 Wealth ratios are then calculated as WR= 5 . A wealth ratio below one means that the investor would
1+rControl
have been better off with an investment in the matched firms.
13 5 5
If, for example, an IPO firm only has four years of returns we use those four years to compute rIPO and also rControl . This procedure mitigates sample selection
bias by not dropping firms with limited return histories.
260
Table 7
Post-IPO ROA and investment rates as a function of initial underpricing.
ROA one year after IPO ROA three years after IPO Investment one year after IPO Investment three years after IPO
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
Constant 0.045*** 0.020*** 0.023*** 0.083*** 0.042*** 0.042*** 0.049*** 0.039*** 0.038*** 0.064*** 0.042*** 0.050***
F. Santos / Journal of Corporate Finance 42 (2017) 247–266

7.38 3.22 3.03 7.39 3.52 3.19 12.75 9.72 8.55 9.59 5.72 6.20
Underpricing −0.061*** −0.010 −0.071*** 0.002 0.183*** −0.002 0.028*** 0.084*** 0.060*** 0.028** 0.128*** 0.028
−3.96 −0.32 −2.93 0.08 2.86 −0.05 3.47 3.36 3.66 2.31 2.89 1.19
Market underpricing −0.181*** −0.201*** −0.051*** −0.124***
−6.55 −4.57 −3.42 −5.68
High month −0.027** −0.007 −0.008 −0.012
−2.21 −0.35 −1.17 −0.97
Underp.× High month −0.103*** −0.263*** −0.076*** −0.146***
−2.94 −3.98 −2.93 −3.25
Num high months −0.007*** −0.004** −0.002*** −0.003***
−6.32 −2.24 −3.21 −3.76
Underp.× Num high months −0.001 −0.004 −0.003*** −0.002
−0.53 −1.55 −3.37 −1.61
Num low months 0.001* 0.002 0.001* −0.000
1.76 1.61 1.72 −0.23
Underp.× Num low months 0.001 0.009* −0.001 0.003
0.38 1.68 −0.52 1.22
N 4523 4523 4523 3336 3336 3336 4480 4480 4480 3313 3313 3313
R2 0.0350 0.0292 0.0394 0.0084 0.0111 0.0121 0.0034 0.0065 0.0107 0.0061 0.0084 0.0070
The sample is composed by U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers, spin-offs, closed-end funds, IPOs with an offer price
below $1.00, Real Estate Investments Trusts (REITS) and financial firms as described by SDC are excluded from our sample. Dependent variables are the difference in ROA and investment rates one year and three
years after the IPO between IPO firms and a portfolio of five public firms matched on book value, market value, industry and operating profitability. Differences are winsorized at the 1% level. Explanatory variables
include: Underpricing as the first-day return of the IPO firm; Market underpricing as the average underpricing the month prior to the IPO; High month dummies equal to one if the month of the IPO is classified as
high underpricing; Num low months and Num high months denote, respectively, the number of consecutive low and high underpricing months prior to each IPO. T-stats based on White corrected and period-clustered
standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
5 5
Table 8 presents rIPO , rControl and WRs for low- and high-underpricing periods, as well as for the robustness periods Only low
and First-four . First-day returns are excluded in Panel A but included in Panel B. The results presented provide empirical support
for H2.
In Panel A, the value from investing in IPO firms in low-underpricing periods is not different from investing in the control
group (WR of 0.95 for Low and 0.94 for Only low ). However, as predicted, for firms going public in high-underpricing periods,
WR is significantly below one (0.51). This is the result of a five-year buy-and-hold return of −1.3 % for IPO firms compared to
69.9% for their peers.
5
In Panel B, we observe the same pattern as in Panel A. rIPO is higher due to average positive first-day returns which, in turn,
enhances WRs. However, we still observe that WRs for IPOs in high-underpricing periods are significantly below one (0.72).
Note that no WR is significantly above one, which is consistent with our model, where firms only accept offer prices that are at
least equal to fundamental value. However, this result is difficult to reconcile with the view that IPO underpricing is a discount
to fundamental value. This discount would imply that investors who were allocated shares during the IPO would be better off
investing in issuers than on their matched firms, generating WRs above one.
Following Ritter (1991) and Loughran and Ritter (1995) among others, we further test IPO long-term performance by com-
puting IPO firms’ CARs, with matched firms as benchmark. Using the same return history as with WRs, we compute monthly
abnormal returns as the monthly return of each IPO firm minus the return of the peer portfolio. For the first month, we include
the first-day return but results are robust to excluding it. For each IPO firm, we compute the five-year CAR by adding all monthly
abnormal returns. We then analyze the relation between CAR and underpricing at the time of the IPO.
Table 9 presents the coefficients estimates from OLS regressions of CAR on underpricing. In column (1), the independent
variables are firm’s underpricing and Market underpricing the month prior to the IPO. Firm-specific underpricing cannot predict
future performance, but the coefficient for Market underpricing is statistically and economically significant. The higher the gen-
eral level of underpricing prior to the IPO, the worse the long-run performance of the issuer. Replacing Market underpricing by a
High month dummy, with Low month as baseline, does not alter the results. The coefficient estimate on High month is significant
and negative, supporting the notion that high underpricing in the market predicts long-run underperformance. To test if this
relation is stronger after several months of high underpricing, we include the number of consecutive high-underpricing months
prior to the IPO in column (3). The coefficient estimate on Num. high months is indeed negative, which implies that firms going
public after several months of high underpricing are the ones displaying the worse performance in the long run, consistent with
H2 and the results based on WRs.
A concern with WRs and CARs is that these measures might not properly control for risk. To address this, we first look
at issuer risk characteristics, namely earnings volatility, return volatility, firm’s beta and delisting likelihood. We retrieve, for
the five-year period following the IPO, quarterly earnings from Compustat, delisting codes and monthly returns from CRSP.
We compute earnings and return volatility as the standard deviation of, respectively, reported quarterly earnings and monthly
returns; and firm’s beta is estimated using the CAPM.
In Panel A of Table 10, we report the results from regressing each risk characteristic on High, with Low as baseline. In Panel
B, the baseline is Only low with First-four and High as independent variables. For delisting rates, we perform Logit regressions
while for the other risk measures we use OLS. To explain our long-run performance results, we should observe less-risky firms
going public in high-underpricing periods, in particular in the end of these periods. We do not find this to be the case, however:
Table 8
Five year wealth relatives between IPO firms and control firms as function of IPO underpricing cycle.
5y 5y
rIPO rControl WR t-Stat
Panel A. Excluding 1st day return

High −1.3% 69.9% 0.51*** −10.74
Low 51.8% 60.2% 0.95 −0.62
Only low 53.2% 62.8% 0.94 −0.79
First-four 26.7% 43.6% 0.88 −1.51
Total 37.4% 63.4% 0.84*** −5.90
Panel B. Including 1st day return

High 22.6% 69.9% 0.72*** −5.61
Low 66.7% 61.7% 1.03 0.96
Only low 66.5% 63.8% 1.02 0.55
First-four 70.1 43.6 1.18 1.13
Total 58.2% 63.4% 0.97 −1.08
The sample is composed by U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
from our sample. In Panel A, five-year buy-and-hold returns 5y
(r ) are computed excluding the first day return; Panel B reports results including the first day
5y 5y
return. Wealth ratios (WR) are calculated as 1 + rIPO / 1 + rControl . Control firms are five public firms matched on book value, market value, industry and
operating profitability. High-underpricing periods (High) consist of all periods with more than four consecutive high-underpricing months, excluding the first
four months (First-four). All months not included in High are classified as low-underpricing periods (Low). Excluding First-four months from Low delivers Onlylow
periods. T-stats based on White corrected and period-clustered standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10% significance
levels.
Table 9
IPO firms’ five-year CARs as a function of initial underpricing.
(1) (2) (3)
Constant −2.021 −2.926 −21.327***

−0.32 −1.03 −2.72
Underpricing −0.125 −0.454* −0.001
−1.53 −1.76 −0.01
Market underpricing −1.068***
−6.36
High month −35.141***
−3.47
Underpricing*High month 16.201
0.60
Num. high months −3.393***
−4.66
Underpricing*Num. high months −1.934
−1.59
Num. low months 1.359
1.63
Underpricing*Num. low months −2.46
−1.44
n 4875 4875 4875
R2 0.007 0.005 0.011
The sample is composed of U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
from our sample. Dependent variable is the five year cumulative abnormal return between IPO firms and a portfolio of five public firms matched on book value,
market value, industry and operating performance. Explanatory variables include: Underpricing as the first-day return of the IPO firm; Market underpricing as
the average underpricing the month prior to the IPO; High month dummies equal to one if the month of the IPO is classified as high underpricing; Num low
months and Num high months denote, respectively, the number of consecutive low and high underpricing months prior to each IPO. T-stats based on White
corrected and period-clustered standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
the coefficient estimates on High are never negative. Actually, if anything, high-underpricing period issuers are riskier as they
exhibit higher return volatility, higher beta and are more likely to be delisted in the five years after the IPO.
For robustness, in Table 11, we present results that do not depend on the IPO underpricing period classification. In column
(1), we regress each risk measure on firm’s underpricing and average IPO underpricing the month prior to the IPO. Again, we do
not find that Market underpricing predicts lower issuer risk. For return volatility and beta, we actually find the opposite. Using
underpricing month dummies instead of market underpricing leads to similar results as seen in column (2). Moreover, from
Table 10
Issuer risk measures as a function of IPO underpricing cycle.
Earnings volatility Return volatility CAPM beta Delisting rate
Panel A — Regression results with “Low” as baseline.

Constant 0.208*** 0.837*** 0.851 0.966
2.90 38.23 68.57 13.55
High 0.005 0.015*** 0.266*** 0.328***
0.05 7.35 5.69 2.75
n 3323 4702 4273 4928
R2 0 0.060 0.038 0.007
Panel B — Regression results with “Only low” as baseline.

Constant 0.215*** 0.047*** 0 .834*** 0.973***
2.69 78.78 69.38 12.92
First-four −0.071 0.009*** 0.028 −0.065
−0.90 5.96 0.57 −0.29
High −0.003 0.016*** 0.269*** 0.321***
−0.03 7.85 5.75 2.63
n 3323 4702 4273 4928
R2 0 0.071 0.038 0.021
High — First-four −0.074 0.007*** 0.241*** 0.386**
Wald test 0.84 43.95 16.57 7.69
The sample is composed of U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers,
from our sample. Dependent variables are earnings volatility, return volatility, CAPM beta and delisting rate for the five-year period after the IPO. Panel A
explanatory variable is High, with Low as baseline. In Panel B, the baseline is Only low with First-four and High as explanatory variables. High-underpricing periods
(High) consist of all periods with more than four consecutive high-underpricing months, excluding the first four months (First-four). All months not included
in High are classified as low-underpricing periods (Low). Excluding First-four months from Low delivers Only low periods. T-stats based on White corrected and
period-clustered standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
Table 11
Issuer risk measures as a function of initial underpricing.
Earnings volatility Return volatility CAPM beta Delisting rate
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
Constant 23.138*** 23.056** 24.653** 4.519*** 4.680*** 4.786*** 0.775*** 0.773*** 0.776*** 0.729*** 0.726*** 0.740***
F. Santos / Journal of Corporate Finance 42 (2017) 247–266

2.93 2.51 2.27 98.38 91.02 81.40 69.54 73.82 48.97 86.88 81.67 73.67
Underpricing −0.046* −0.083 −0.070 0.001 0.007** 0.009*** 0.004*** 0.006*** 0.005*** −0.000 −0.001 −0.000
−1.77 −1.25 −1.05 1.43 2.43 6.03 11.52 9.74 6.52 −0.41 −1.40 −0.30
Market underpricing −0.058 0.030*** 0.002*** 0.000
−0.60 14.41 3.80 1.16
High month −2.245 1.077*** 0.083*** 0.046***
−0.20 11.20 3.79 3.05
Under*High 3.001 −0.045 −0.162** 0.049
0.38 −0.15 −2.37 1.13
Number high months 0.012 0.109*** 0.012*** 0.001
0.01 11.63 5.60 0.90
Under num high −0.040 −0.038*** −0.010* 0.000
−0.07 −3.10 −1.94 0.13
Number low months −0.353 −0.006 0.000 −0.001
−0.89 −1.42 0.04 −1.29
Under*Num low −0.159 −0.034* −0.008 −0.001
−0.64 −1.94 −1.38 −0.37
n 3316 3316 3316 4635 4635 4635 4219 4219 4219 4859 4859 4859
R2 0 0 0 0.088 0.067 0.083 0.127 0.126 0.133 0 0.032 0.011
The sample is composed of U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC). Unit offers, spin-offs, closed-end funds, IPOs with an offer price below
$1.00, Real Estate Investments Trusts (REITS) and financial firms as described by SDC are excluded from our sample. Dependent variables are earnings volatility, return volatility, CAPM beta and delisting rate for the five
year period after the IPO (logit regression). Explanatory variables include: Underpricing as the first-day return of the IPO firm; Market underpricing as the average underpricing the month prior to the IPO; High month
dummies equal to one if the month of the IPO is classified as high underpricing; Num Low Months and Num high months denote, respectively, the number of consecutive low and high underpricing months prior to
each IPO. T-stats based on White corrected and period-clustered standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10% significance levels.
263
column (3), we find that issuer risk increases with the number of high-underpricing months prior to the IPO, inconsistent with
risk being the reason for the long-term underperformance of these issuers.
At last, we evaluate the IPO risk-adjusted long-run performance using factor regressions. First, we design trading strategies
that go long in issuers and short in matched firms. For each month in high-underpricing periods, we construct a self-financed
portfolio by buying IPO firms (at the offer price) and shorting their control group. We track the monthly return of each long-short
portfolio for five years. When the gap between two consecutive high-underpricing periods exceeds five years, some months will
have no returns. For every month with at least one return, we compute the average return of all overlapping portfolios. This
monthly average return is then regressed on a five-factor model consisting of the three Fama–French factors (Fama and French,
1993), momentum (Jegadeesh and Titman, 1993; Carhart, 1997), and the traded liquidity factor of Pastor and Stambaugh (2003).
We repeat his procedure for Low and, as robustness, for Only Low and First-Four.
Alphas and factor loadings are presented in Table 12. In Panel A, we see that alphas are not significant for Low, Only low
and First-four . However, for IPO firms in high-underpricing periods, we find a marginally significant negative monthly alpha of
53 bps (p-value of 5.21%). Although, this result is not as strong statistically as the previous results in this section, it is still large
economically, amounting to an annual compounded alpha of −6.55 %.
Overall, using wealth ratios, cumulative abnormal returns and factor regressions, we find support for H2 as issuers in high-
underpricing periods tend do underperform in the long run, while issuers in low-underpricing periods do not.
5. Conclusion
In this paper, we develop a simple model where the decision of going public is driven by investment opportunities and by
sentiment investors’ overvaluations. Firms prefer to go public in periods when sentiment-driven investors are overly exuberant.
In these periods, issuers can take advantage of overvaluations by setting offer prices above fundamental value. But, at the time
firms decide to go public, the presence of retail investors in the aftermarket is uncertain. Thus, offer prices depend on expected
aftermarket demand. The more likely the presence of retail investors in the aftermarket, the higher the offer price.
Good firms, however, have profitable, short-lived, investments opportunities that require immediate finance. Good firms
can be lucky and have projects in periods when they can exploit aftermarket overvaluations. But, occasionally, they might have
to decide between financing the investment opportunity immediately and postponing the IPO until market conditions have
improved. If the NPV of the project is sufficiently high, firms are better off going public even when they do not expect retail
demand to drive IPO shares in the aftermarket.
In equilibrium, the investment opportunities and the pricing of issues vary with the expected aftermarket demand. More
precisely, the model generates two empirical predictions: the quality of the issuers’ investments and their long-run performance
decrease with expected retail demand.
We test the two empirical predictions of the model using underpricing as a proxy for retail demand. Analyzing operating
profitability and investment rates, we provide empirical support for the first hypothesis. The results suggest that issuers in low-
underpricing periods use the IPO proceeds to exercise investment opportunities, while issuers in high-underpricing periods lack
profitable projects.
We also find empirical support for the second hypothesis. Analyzing wealth ratios, cumulative abnormal returns and factor
regressions, firms that go public in high-underpricing periods tend to underperform in the long run, while issuers in low-
underpricing periods do not.
Table 12
Jensen’s alphas and factor loadings.
a RM SMB HML UMD LIQ Adj.-R2
High −0.53* 0.10 0.06 −0.34** −0.02 −0.45** 0.056

−1.95 1.37 1.17 −2.31 −0.11 −2.03
Low 0.08 0.07 0.12 −0.13** −0.01 −0.23* 0.062
0.62 1.47 1.53 −2.22** −0.31 −1.87
Only low 0.07 0.05 0.14 −0.13** −0.02 −0.24* 0.064
0.41 1.21 1.44 −42.03** −0.28 −1.91
First-four −0.01 0.05 0.08 −0.16* −0.02 −40.28* 0.061
−0.31 1.01 1.35 −1.95** −0.17 −2.05
The model is: rtIPO − rtControl = a + b0 RMt + b1 SMBt + b2 HMLt + b3 UMDt + b4 LIQt + et where rtIPO − rtControl is the excess return on a zero investment portfolio
that goes long in IPO firms and short in matching firms. Portfolios are formed every month and held for five years. RM is the excess return on a value-weighted
market index, SMB and HML are the Fama–French size and book-to-market factors, UMD is the Carhart momentum factor, and LIQ is the Pastor and Stambaugh
liquidity factor. The sample is composed of U.S. IPOs completed between January 1, 1973 and December 31, 2009 as reported by Securities Data Company (SDC).
Unit offers, spin-offs, closed-end funds, IPOs with an offer price below $1.00, Real Estate Investments Trusts (REITS) and financial firms as described by SDC are
excluded from our sample. High-underpricing periods (High) consist of all periods with more than four consecutive high-underpricing months, excluding the
first four months (First-four). All months not included in High are classified as low-underpricing periods (Low). Excluding First-four months from Low delivers
Only low periods. T-stats based on White corrected and period-clustered standard errors are presented. ***, ** and * represent, respectively, 1%, 5% and 10%
significance levels.
The main contribution of the papers is to provide an explanation for why more firms go public as underpricing increases. This
has been a puzzle because, if underpricing is a discount to fundamental value, it is difficult to understand why more firms go
public when this discount increases. We argue that high underpricing reflects high aftermarket retail demand paying a premium
to fundamental value, which creates an incentive for all firms to go public. However, it still remains to understand why investors
from time to time become overly exuberant and prone to overvaluations.
Acknowledgments
We thank an anonymous reviewer, Anat Admati, John Beshears, Liran Einav, Dirk Jenter, Ilan Kremer, Charles Lee, Andrey
Malenko, Nadya Malenko, Francisco Perez-Gonzalez, Ilya Strebulaev, Karin Thorburn, Yanruo Wang and Jeffrey Zwiebel, and
seminar participants at AFBC (Sydney), NHH (Bergen), Nova School of Business & Economics, Portuguese Catholic University,
University of Bergen, University of Porto, and WFBS (Singapore).
Appendix A. Propositions’ proofs
A.1. Proof of Proposition 1
Bad firms’ case:

X(1−d)
In Period I, Bad firms receive offer price OI (B, H) = 1−d(1+u) which exceeds firms’ fundamental value X. Firms then compare
OI (B, H) with expected offer price in Period II, E[OII (B, DII,1 )]. With probability d, DII,1 = H and Bad firms receive OII (B, H) =
Xd
OI (B, H). However, with probability 1 − d, DII,1 = L and Bad firms receive OII (B, H) = 1−(1−d)(1+u) < OI (B, H). Because OI (B, H) >
X(1−d) Xd
E [OII (B, DII,1 )] = d 1−d(1+u) + (1 − d) 1−(1−d)(1+u) , Bad firms go public in Period I when DI,1 = H.
Good firms ’ case
Recall that Good firms have short-lived profitable investment opportunities. These can only be exercised if firms go public in
Period I. If firms wait, their fundamental value reverts to X. In Period I, Good firms receive offer price OI (G, H) = (X+C−K)(1−d)
1−d(1+u)
> X.
Firms then compare OI (G, H) with expected offer price in Period II, E[OII (G, DII,1 )]. With probability d, DII,1 = H and Good firms
X(1−d) Xd
receive OII (G, H) = 1−d(1+u) < OI (G, H). With probability 1−d, DII,1 = L and Good firms receive OII (G, L) = 1−(1−d)(1+u) < OI (G, H).
X(1−d) Xd
Because OI (B, H) > E [OII (B, DII,1 )] = d 1−d(1+u) + (1 − d) 1−(1−d)(1+u) , Good firms go public in Period I when DI,1 = H.
A.2. Proof of Proposition 2
Bad firms’ case:

Xd
In Period I, Bad firms receive offer price OI (B, L) = 1−(1−d)(1+u) > X. Firms then compare OI (B, L) with expected offer price in
Period II, E[OII (B, DII,1 )]. With probability d, DII,1 = L and Bad firms receive OII (B, L) = OI (B, L). However, with probability 1 − d,
X(1−d) Xd X(1−d)
DII,1 = H and Bad firms receive OII (B, H) = 1−d(1+u) > OI (B, L). Because OI (B, L) < E [OII (B, DII,1 )] = d 1−(1−d)(1+u) + (1 − d) 1−d(1+u) ,
Bad firms do not go public in Period I when DI,1 = L.
Good firms ’ case
(X+C−K)d
In Period I, Good firms receive offer price OI (G, L) = 1−(1−d)(1+u) > X. Firms then compare OI (G, L) with expected offer price
Xd
in Period II, E[OII (G, DII,1 )]. With probability d, DII,1 = L and Good firms receive OII (G, L) = 1−(1−d)(1+u) < OI (G, L). However, with
X(1−d)
probability 1 − d, DII,1 = H and Good firms receive OII (G, H) = 1−d(1+u)
, which can be higher than OI (G, L) depending on values of
C, K, d and u. So, E [OII (G, DII,1 )] = Xd
+ (1 −
d 1−(1−d)(1+u) d) 1−d(1+u) . If C − K ≥ kX, where k = −u(1−d)(1−2d)
X(1−d)
d[1−d(1+u)]
, OI (G, L) ≥ E[OII (G, DII,1 )],
and Good firms go public in Period I when DI,1 = L, otherwise they wait.
Appendix B. Earnings announcement sample
To compute earnings announcements surprises we retrieve data from I/B/E/S from January 1, 1984 to December 31, 2009. We
obtain all quarterly earnings announcements for which there is at least one analyst forecast 90 days before the announcement.
We only keep the forecast closest to the announcement date yielding a sample of 316,873 observations. Following DellaVigna
and Pollet (2009), we also use earnings announcement dates from Compustat. The sample is restricted to observations for which
there are announcements dates on I/B/E/S and Compustat and the difference between the two dates is less than five days. This
yields a sample size of 183,873 observations. In order to impute a unique date to each earnings announcement, we follow the
optimal imputation rule used in DellaVigna and Pollet (2009):
• when I/B/E/S and Compustat dates disagree, the announcement date is assumed to be the earliest;
• for the period before January 1, 1990 if the two dates agree, the announcement date is assumed to be the previous trading
day;
• for the period after January 1, 1990 if the two dates agree, we assume it as the announcement date.
Earnings surprises are defined as in Kothari (2001): the difference between expected and actual earnings per share normal-
ized by share price. I/B/E/S consensus analyst forecast (median forecast among all analysts) proxies for expected earnings. To
avoid any noise in prices, we use the price seven business days before the announcement date. Share prices are obtained from
CRSP. All observations for which prices are not available and all penny stocks (price below $1) are dropped, which reduces the
e −ê
sample to 175,508 observations. We then compute st,k , the earnings surprise for firm k in quarter t, as st,k = t,kp t,k , where et,k
t,k
and êt,k are, respectively, the actual and forecasted earnings per share of firm k in quarter t and pt,k the corresponding price seven
business days before the announcement date. We drop 124 observations for which the actual earnings are larger in absolute
value than the price of the share.
Given that market reaction to earnings surprises may be non-linear, we decide to follow DellaVigna and Pollet (2009) and
sort surprises into 11 quantiles. Quantiles 1 to 5 contain negative surprises with the most negative ones in quantile 1. Quantile
6 has all announcements with no surprises, while positive earnings surprises are in quantiles 7 to 11. The breakpoints for the
quantiles are computed year by year. We do not have the same number of observations per bin because we have more positive
than negative surprises.
We next obtain cumulative abnormal returns for the day of the announcement and the next one. For such, we gather daily
returns from CRSP and estimate betas for each firm-quarter observation from the regression: Ru,k = a t,k + bt,k Ru,m , where Ru,k
and Ru,m are, respectively, the daily return for firm k and market at day u and u ∈ [t−300, t−45] with t being the announcement
date. Given b, we compute buy and hold abnormal return for the two-day announcement window for firm k, quarter t as
Rt,t+1
t,k
= Pt+1j=t
(1 + Rj,k ) − 1 −
bt,k Pt+1
j=t
(1 + Rj,m ) − 1
Finally, we obtain from Compustat market capitalization and book-to-market for each firm-quarter observation. This yields
a final sample of 175,384 observations.
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Journal of Corporate Finance 42 (2017) 247–266

Contents lists available at ScienceDirect

Journal of Corporate Finance

IPO market timing with uncertain aftermarket retail demand

E-mail address: francisco.santos@nhh.no (F. Santos).

2.1. Model setup

2.2. The IPO process

Solving for the offer price Ot yields:

Fig. 1. Model timeline.

2.4. Empirical predictions

3. Sample selection, retail demand and control ﬁrms

3.1. Sample selection and issue characteristics

1973 5 25.2% 7.8 39 1.9 9.7

3.2. Retail demand and underpricing

# % Months in # Period length (in months) # IPOs % IPOs in First-day Underwriter

Panel A — Full sample divided by months

Panel B — Full sample divided by periods

Panel C — Robustness classiﬁcation

Turnover Number of trades

Panel A — Regression results with “Low” as baseline.

Panel B — Regression results with “Only low” as baseline.

3.3. Control ﬁrms

(1) (2) (3) (4)

Constant 0.0010*** 0.0025 0.0035 0.0043*

4.1. Issuers’ investment quality across the IPO underpricing cycle

IPOs Peers Diff. t-stat

Panel A — Entire sample

4.2. Issuers’ long-run performance across the IPO underpricing cycle

One year after the IPO

ROA Investment rate

n IPOs Peers Diff. t-Stat n IPOs Peers Diff. t-Stat

Panel A — Average across periods.

Panel B — Regression results with “Low” as baseline.

Panel C — Regression results with “Only low” as baseline.

Three years after the IPO

ROA Investment rate

n IPOs Peers Diff. t-Stat n IPOs Peers Diff. t-Stat

Panel E — Regression results with “Low” as baseline.

Panel F — Regression results with “Only low” as baseline.

F. Santos / Journal of Corporate Finance 42 (2017) 247–266

Panel A. Excluding 1st day return

Panel B. Including 1st day return

(1) (2) (3)

Constant −2.021 −2.926 −21.327***

Earnings volatility Return volatility CAPM beta Delisting rate

Panel A — Regression results with “Low” as baseline.

Panel B — Regression results with “Only low” as baseline.

Earnings volatility Return volatility CAPM beta Delisting rate

F. Santos / Journal of Corporate Finance 42 (2017) 247–266

a RM SMB HML UMD LIQ Adj.-R2

High −0.53* 0.10 0.06 −0.34** −0.02 −0.45** 0.056

Appendix A. Propositions’ proofs

A.1. Proof of Proposition 1

Bad ﬁrms’ case:

A.2. Proof of Proposition 2

Bad ﬁrms’ case:

Appendix B. Earnings announcement sample

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High −0.53* 0.10 0.06 −0.34 −0.02 −0.45 0.056