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1 Online Open Access publishing platform for Management Research Copyright by the authors Licensee IPA Under Creative Commons license 3. Research Article ISSN ABSTRACT IPO Pricing Evidence from Indian Capital Market Institute of Management Technology, Nagpur In India, the prospectus, issued by the firm going to public, have a calculation of offer price based on historical financial information (EPS, Profitability, P/E ratio etc). However, on the day of listing, list price (listing day closing price) significantly differs from the initial offer price and thereby confirms the presence of underpricing anomaly. The difference between offer price and list price substantiates the presence of few unaccounted variables which have dominance over the initial offer price calculated using historical financial information. The pricing of IPOs is puzzle to the participants of primary market. In the absence of any specific method, subscribers are using different approaches to decide the offer price. This gives differential returns to different investors. This paper studies the pricing of IPOs offered in Indian capital market during 2725 using stepwise regression. The study found four, accounting and two, market related factors are explaining around 62.6% of the offer price. Granger Causality test shows the bidirectional relationship between dependent and independent variable. Age of the firm, a significant variable in earlier studies found insignificant in this study. This shift is interpreted as investors are valuing future potential than the historical parameters. Key words: IPO, IPO pricing, new issues (IPOs), Indian capital market, IPO offer price.. Introduction Very few information about the issuing firm is available to the market prior to their entry to the primary capital market. This study is to examine the fundamental accounting and market related factors contributing to decide the offer price of the new issues. This study focuses on the pricing of the new issues in the Indian Capital Market during January 27 to December 25. It is argued that the prospectus issued by the offering firms, to some degree, has considerable explanatory power to the pricing of new issues. Since the new issues can be priced with many methods, the circumstance is even more difficult for the investors to value the offer. 2. Literature pricing of new issues 2. International references In equity valuation, the assumption is made that market price differs from the company s intrinsic value. The intrinsic value approach was proposed by Professor Benjamin Graham and David Dodds in their book Security Analysis published in 934 following unprecedented losses on Wall Street, USA (Graham & Dodds, 934). They laid down the 4

2 foundations for the value investing which could be simply described as buying the securities whose shares appear to be underpriced. In other words, value investing means buying stock at less than their intrinsic value. Benjamin Graham taught Warren Buffet and not surprisingly Buffet s Berkshire Hathaway contributed to further development of the value investment concept. The intrinsic value is calculated with the use of some form of fundamental analysis, which according to Penman (2) is the method of analyzing current and past financial statements, macroeconomic, industry and firm s specific information in order to arrive at a firm s intrinsic value. Therefore the main purpose of fundamental analysis used by investors is to identify mispriced stocks. Many academicians and investors were in search of models for valuation of equity stock. Till date, numbers of valuation models are suggested by economist and finance professionals. Early 98s period marked by emergence of signaling theory, where post issue retention by pre issue share holder is proved as one of the most influential value driver. Empirical evidence by Leland and Pyle (977), Ritter (984), Kim et al (995), Klein (996) and found positive relationship between post issue promoter group holding and offer price of new shares. Keasey and McGuinness (992) investigate the role of signaling theory in new issue valuation. By using sample of 9 new issues during in UK, they found that post issue retention by pre issue holder, level of planned capital expenditure, under price level, quality of reporting accountants (Auditors) and floatation cost are positive and significant in influencing offer price of new issues. Other signaling variables such as underwriters prestige and audit quality were studied by Krinsky and Rotenberg (989) and Feltham et al (99) respectively. Late 99s focused on financial information as key driver for valuation of new issues. McGuiness (993) studied the market valuation of 92 new issues in Hong Kong during He found that the publicly available information likes historical earnings and net assets were significantly influence the initial offer price of the new issues. Other variables like debt ratio, age of the firm and percentage change of market index found positive influence on offer price. Klein (996) investigates the explanatory power of accounting variables and other items contained in the prospectus on sample of 93 new issues from years 989. She concludes that accounting information is important in the pricing of new issues. Her findings include significant relationship between earning per share and book value of equity with offer price. Her study found positive relationship between percentages of shares retained by pre offer investor, investment bank prestige and offer price. Risk warning on the cover page of the prospectus was found to be negatively related to the offer price. However, her measurement of book value is problematic because it uses ex post information affected by the offer price to explain the offer price itself. Kim and Ritter (999) paint a rather bleak picture of the explanatory power of accounting comparables, suggesting that new issues pricing is largely unrelated to historical accounting information. One interpretation of their results is that underwriters and investors build their cash flow and discount rate estimates with vastly different information. They investigate the correlation between firm level price earning (P/E) ratio s and the industry median PE ratio s for a sample of 9 new issues with positive preipo income and completed in the years 992 and 993. They acknowledged that firm level and industry level PE ratios are positively related with adjusted R 2 of only.5. Studied model was further improved by replacing trailing PE with forward PE. They conclude that variables with historical information are of limited importance for understanding new issues pricing. 5

3 Beatty, Riffe and Thompson (2) question the Kim and Ritter s (999) findings regarding low relevance of historical accounting information in pricing of new issues. Because of use of only industry multiple in their regression, their model captures only time and industry variation and remain silent on firm specific accounting information. Using sample of 2577 new issues with positive earnings and positive book value for the year 98798, they found R 2 about 4% (which was 5% in Kim and Ritter (2)) explaining relationship between offer price and earnings, book value and revenues. Also, R 2 was between 69% when all variables either deflated by book value of equity or sales or log transformed. Barniv and Myring (26) found influence of historical book values and earnings on offer price of new issues. Bhagat and Rangan (24) and Aggarwal et al (29) examined effect of both, financial and signaling variables on offer price of new issues. Aggarwal (29) studied 655 new issues during three different periods i.e boom (January 997 to March 2), Crash (April 2 to December 2) and normal period (986 to 99). Their study confirmed shift in valuation fundamentals across the time period. They found that income has more influential than sales during boom period while book value of equity found highly correlated with offer price during crash period. Bartov et al (22) investigate set of financial and non financial variables for a sample of 98 (internet) new issues during They found that internet firms considers negative cash flows as investment and therefore have higher influence than positive cash flows on offer price of new issues. Whereas for noninternet new issues, they found positive cash flows are significant and negative cash flows as insignificant in relation with offer price of new issues. 2.2 Literature with reference to India Sahoo S and Rajib P (22) investigate the new issues by using market average P/E, delay in listing along with set of financial and signaling information. Sample of 72 new issues during 2227 were studied to conclude market P/E, as measured by BSE sensex, book value per share earnings per share, new issues activity period, investment bank prestige, subscription to the issue and post issue promoter holding were significant and positively affecting offer price and list price. Their findings further confirmed that book building mechanism commands higher prices than fixed priced offers and adverse effect of listing delay. Sahani D and Mehandiratta S (23) studied to analyze the factors affecting the pricing of new issues that come out in the primary market. In order to study the IPO market an understanding between risk and reward had been studied. A sample size of companies was selected those who offered equity holding to the public during 24 to 2 and these companies belong to different sectors of the economy. This main objective was achieved by studying the important factors affecting the pricing of an IPO and to know what role they played in the investment pattern of an Indian investor. Jaitly S and Sharma R (24) investigate the pricing of new issues in the Indian equity market during the period shortly following the deregulation of the market for new issues. He evaluate the importance of book value and market value estimates in determining issue prices as well as prices on the first day of trading. He also use variables that may reduce uncertainty (age to proxy for awareness of the company) and information asymmetry (the extent of the promoter s contribution to the new issue) in order to test whether uncertainty and information 6

4 asymmetry have an impact on pricing of new issues. Results indicate that pricing of new issues appears to be consistent with rational decision making. Although it is difficult to come out with an accurate measure for new issues pricing, this study is further extension to existing literature in terms of predicting power and number of significant variables of our pricing model with reference to emerging market like India. 3. Research objective The present study is carried out with following research objective of to identify and study the variables affecting the offer price of IPOs floated in Indian Capital Market during Research methodology 4. Sources of data This study is based on secondary data. The list of new issues during period of study (January 27 to December 25) is obtained from website of National Stock Exchange (NSE). Based on the literature review, numbers of variables are identified for the purpose of the study. Data about the identified variables like sales, profitability, net worth, cash flow, rate of dividend, post issue promoter shareholding, total assets, leverage, P/E ratio, EPS and age of the issuing company is obtained from the prospectus issued by the issuer company at the time of public offer which are available on website of Securities and Exchange of India (SEBI). Since most of the issues are using book building mechanism, offer document (prospectus) do not disclose the offer price. Rather it mere gives a price band to bid. Similarly few variables like oversubscription, listing day list price can be ascertained after the closing of the issue. Therefore the data regarding final offer price, issue opening date, closing date, listing date and issue size, industry, and oversubscription of the issue has been taken from capitaline database. In case of nonavailability of data on capitaline database, the opening, closing and listing date of issues and opening day opening price and opening day closing price are obtained from reliable websites as referred in bibliography. 4.2 Sample construction for under pricing The sample size to study the IPO offer price is derived as per following table: Table : Sample Construction for Pricing Particulars No. of New Issues All listed new issues during the period of study ( January 27 December 25) 34 Follow on Public Offers (FPOs) (8) Missing data (35) Outliers deletion (2) Valid Cases Selected for the Study (79.3%) 249 Source: Author s Construction 7

5 4.3 Techniques of data analysis IPO Pricing Evidence from Indian Capital Market The descriptive statistics such as mean, median and measures of dispersion like standard deviation and variance are used for preliminary analysis of the data. Measures of Association (Correlation and Linear Regression) are applied to identify proportion of variation in the dependent variable explained by the independent variables. A Granger Causality test proposed by Granger (969) is done between each of the significant variable with the dependent variable to decide the direction (unidirectional or bidirectional) causality between the variables. The assumption of Stationary of variables is tested using Augmented Dickey Fuller (ADF) test. 4.4 Results of regression analysis Following regression equation can be framed on the basis of coefficients table generated from the analysis (See Table2) OPxyi = L_IssueSizei + 3.2Profitabilityi+.6Industry_P/Ei.4Operating_Cashi 4.4Leveragei + 2.5L_Salesi Table 2: Regression Coefficients Offer Price is DV Unstandardized Standardized Collinearity Coefficients Coefficients Statistics t Sig. Std. B Beta Tolerance VIF Error (Constant) L_Issue Size Profitability Industry P/E Operating Cash Leverage L_Sales Source: Author s Computation R Table 3: Regression Model Summary Dependant Variable is Offer Price Std. Change Statistics Adjusted Error of R R Square the Square df df2 R Square F Change Sig. F Change Durbin Watson Estimate Change Source: Author s Computation Total 8 variables are regressed against dependent variable offer price. As mentioned in Table 3, it is found that 62.6% variation in offer price is explained by explanatory variables. Of the 8 variables, 6 are found to be statistically significant at % (see table 2). Explanatory variables can be classified into two categories i.e. Firm characteristics and market related variables. Profitability, EPS, Operating cash and Leverage are the firm related fundamental accounting variables. Results showed that offer price is not biased but equally dependent on firm s characteristics as well as market related factors. Accounting information is denoted as 8

6 value relevant if there is a statistical association between the accounting numbers and market values of equity (Leif Atle Beisland, 29) 4.5 Discussion on significant variables 4.5. Issue size and industry P/E The present study finds variable issue size significant (β = 4.25, p =.) and positively related to the offer price. However the beta coefficient during the research period is very high. This indicate a change in issue size by one million (as issue size is measured in million), will increase offer price by Rs This finding has interesting interpretation. Issue size is the multiplication of number of shares offered and offer price. When large issues are offered with small offer price it increases number of shares to be offered. Earnings per share (EPS = Profit after tax and preference dividend / Number of equity shares outstanding) used by the investor as decision making tool while investing money into capital market. As number of share is in denominator, higher the number lesser will be the EPS for same amount of profit. Results of this study intensely throwing light on investors tendency to generate higher EPS for their holdings. It can be further inferred that for higher issue size, large investors willing to pay higher price to keep small investors away from the subscription. The logic is further strengthen by significant and positive relation between industry P/E (β =.6, p =.) and offer price. Positive relation between industry P/E and offer price can be interpreted that the profitability translates into higher prices of the new issues. These results are in consistent with Ghicas et al., (2). Similar results for industry P/E signify investor s consideration towards industry parameters along with firm specific characteristic Leverage The ratio of book value of long term debt to paid up equity capital has been used as proxy for the financial risk of the firm. It is commonly believed that higher the pre IPO leverage more is the exante uncertainty in the post listing market (Rasheed et al., 997). The study found negative coefficients for the leverage (β = 4.4, p =.). These results are in line with the findings of Shaoo S and Rajib P (22) in terms of direction of relation between leverage and offer price. The findings indicate leverage as significant (p =.), in contradiction with Shaoo S and Rajib P (22) and Ross (977). It depends on the objectives of floating the new issue. Firms planning to repay the pre IPO debt with equity raised during new issue offer, they may experience better financial soundness in post IPO period (Sarkar et al., 25). Equity and debt are two suppliers of funds for the corporate entity. While calculating profit, all costs incurred by the firms are distributed in stepwise manner starting from outside suppliers followed by debt providers and finally to the owners of equity capital. The presence of debt in capital structure decides the returns to equity capital and this study brilliantly prove this relationship. Negative coefficients of leverage point toward investors are unwilling to pay higher offer price for firms having more debt. Therefore this can confirm the financial literacy of the primary market investors who are interested in protecting their share of profitability Profitability, sales and operating cash 9

7 These three variables are interrelated with each other. Results of the present study found significant variance between maximum and minimum values of Profitability along with high standard deviation, which indicate asymmetric distribution of the variable. With (β = 3.2, p =.) profitability is positively related with offer price. This study found profitability, operating cash (β =.4, p =.), as well as sales (β = 2.5, p =.2), all variables as significantly affecting the offer price of the new issues. However, the regression coefficient of the operating cash is too low to affect the offer price of the new issues in down side direction. Higher sales do not guarantee higher profits to the firm. Profitability is the ratio of two accounting terms while sales is standalone numbers. Significance of profitability and sales proves the analytical approach of applicant to the new issue. Revenue generated by way of sales may wipe out due to higher operating cost and financial obligation. But subscribers to new issues are favoring relative measures (profitability) as well standalone (sales). Significance of profitability and sales indicates rational judgment of subscribers of the new issues towards the analysis of operating and financial costs incurred by the firm. Subscribers to the new issues are giving due weighted to the top as well as bottom line of the issuing firm. The results of pricing model are encouraging. Pricing is found to be indifferent between the four different dependent variables. Majority of the new issues floated during the research period are oversubscribed. This indicates that the Indian investor attraction towards equity investment. However, results are evidence for inclination of firm s specific characteristic than external factors while deciding judgment parameters. The determinants of the pricing traced in the present study have significant implication for all participants in the primary market. Findings on relationship between accounting variables and offer price can be used as signal for charging premium on offer price. Investors gave more weighted to fundamental accounting factors such as profitability, operating cash and leverage than market related factors like issue size, industry P/E. These results intensely speak about investor s sentiment while applying to the new issues Results of granger causality test Form the below table it can be interpreted that the profitability causes offer price but offer price does not causes profitability. The variable profitability helps in deciding the offer price of the new issues. Of the 6 significant variables, profitability at % and leverage at % is showing unidirectional relationship with the dependent variable offer price. In rest of the cases the relationship is bidirectional. The bidirectional relationship may be due to some other issuer specific or market related factors. On the basis findings of the study, a formula for expected offer price is suggested to the prospectus investor of the primary market. Investors are advised to use the regression coefficients (Table 2) with the respective variables. The resultant under pricing and offer price will be an indicative value based on the data analyzed during research period. A variation between actual and predicted value may be due to the factors which are not part of the study Variables N Table 4: Descriptive Statistics Std. Mea Medi Deviati Variance n an on Minim um Maxim um Offer

8 Price 58 L_Issue Size Industry P/E Operating Cash Profitabili ty EPS 249 Post Issue Promoter Share Holding Leverage L_Sales L_Issue Size Industry P/E Operating Cash Profitabil ity EPS Post Issue Promoter Share Holding Leverage L_Sales Off er Pri ce L_S ize In d P/ E Table 5: Correlations matrix Opera ting Cash Profita bility. EP S Source: Author s Construction for both the tables Post Issue Promote r Share Holding Lever age.25 L_S ales.35.3 Sig ( tail ed

9 Table 6: Granger causality tests for offer price Obs FStatistic Prob. L_Sales does not Granger Cause Offer Price Offer Price does not Granger Cause L_Sales Leverage does not Granger Cause Offer Price ** Offer Price does not Granger Cause Leverage * Operating Cash does not Granger Cause Offer Price Offer Price does not Granger Cause Operating Cash Profitability does not Granger Cause Offer Price * Offer Price does not Granger Cause Profitability Industry PE does not Granger Cause Offer Price Offer Price does not Granger Cause Industry PE L_Issue Size does not Granger Cause Offer Price Offer Price does not Granger Cause L_Issue Size * and ** indicates unidirectional at 5% and % p values greater than % indicate bidirectional relationship 5. Conclusion The retail investor is looking IPOs as one of investment options. But the quality of information he have is different than the institutional investors. This study will be useful to the retail investors to understand the past happenings in terms of pricing of the IPOs, which may help them to take their investment decisions. The market regulator can consider this study as reference for revising the guidelines regarding information disclosure in the offer document. The findings of the study conclude that loss to the issuers in terms of money left on the table. Issuer may use findings of this study to decide the pricing of their public offer and reduce the notional loss by reducing gap between offer price and list price. The information disclosed by the issuer company in the prospectus of the company plays vital role in the process of finalizing offer price. At the same time market sentiments are equally important. Out of six variables significant to the offer price, four are fundamental accounting variables and two are market related. This can be interpreted as the investors are not only dependent on preipo accounting information of the company but also industry comparable and market indicator occupying place in investment decisions. Few issuers have to withdraw their IPOs for not getting enough subscription indicates a difference in the method of determination of offer price by issuers and investors. But finally, the investor decided offer price prevail issuers calculation about the same. The purpose of floating an IPO is to raise funds from the capital market; its pricing puzzle is exposing issuer towards notional loss in terms of huge money left on the table. Though the offer price is predominantly decided by fundamental accounting variables during preipo period, the listing gain to investors indicates investors are having over expectation about increment in price beyond offer price. 2

10 6. References. Aggarwal, R., Bhagat, S. & Rangan, S., (29), The Impact of Fundamentals on IPO Valuation. Financial Management, 38(2), pp Barniv, R. and Myring, M. (26), An International Analysis of Historical and Forecast Earnings in AccountingBased Valuation Models. Journal of Business Finance & Accounting, 33, pp Bartov, E., Mohanram, P. and Seethamraju, C. (22), Valuation of Internet Stocks An IPO Perspective. Journal of Accounting Research, 4, pp Beatty, R., Riffe, S., and Thompson, R. (2), IPO Pricing with Accounting Information. Southern Methodist University working paper downloaded from leedsfaculty.colorado. edu 5. Bhagat, Sanjai and Rangan, Srinivasan, (24), IPO Valuation in the New and Old Economies (February 23), AFA 24 San Diego Meetings. 6. Damodaran, A., (22), Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley 22, New York. 7. Feltham, G. A., J. S. Hughes, and D. Simunic. (99), Empirical assessment of the impact of auditor quality on the valuation of new issues. Journal of Accounting and Economics, pp Gordon, M. J., (962), The Investment, Financing and Valuation of the Corporation, R. Irwin, Homewood Ill. 9. Jaitly, S. and Sharma, R. (24), Pricing of IPOs and Their After Issue Performance in the Indian Equity Market, Managerial Finance, 3(), pp K. Keasey, P. McGuinness, H. Short. (992), New Issues Of The U.K. Unlisted Securities Market: The Ability Of Entrepreneurs To Signal Firm Value, Small Business Economics, 4(), pp Kim, M., and Ritter, J. R. (999), Valuing IPOs, Journal of Financial Economics 53, 3, pp Klein, A. (996), Can Investors Use the Prospectus to Price Initial Public Offerings? The Journal of Financial Statement Analysis 2, pp Krinsky, Rotenberg W. (989), Signaling and the Valuation of Unseasoned New Issues Revisited, Journal of Financial and Quantitative Analysis 24(2), pp Leland and Pyle, (977), Papers and Proceedings of the 35 th Annual Meeting of the American Finance Association, New Jersey, September 68, 976 pp

11 5. McGuinness, P., (992), An examination of the underpricing of initial public offerings in Hong Kong: Journal of Business Finance and Accounting, 9, pp Mcguinness P, (993), The postlisting return performance of unseasoned issues of common stock in Hong Kong. Journal of Business Finance and Accounting, 2, pp Penman S. (2), Financial Statement Analysis and Security Valuation New York, NY: McGrawHill International Edition 8. Ritter, Jay R, (984), The Hot Issue Market of 98, Journal of Business, 32, pp Sahani D, and Mehandiratta S. (23), A Study on the Factors Affecting Pricing of India s Ten Largest IPOs, Zenith International Journal of Business Economics & Management Research,3(8), pp Security Analysis by Benjamin Graham and David Dodds, (28) 6 th ed. McGraw Hill. 4