THE OPENING PRICE PERFORMANCE OF INITIAL PUBLIC OFFERINGS OF COMMON-STOCK

Initial public offerings (IPOs) of common stock are followed in the immediate aftermarket by sizeable increases in stock prices on average. The large initial returns of IPO shares have attracted a great deal of attention in the empirical and theoretical literature of finance, and IPOs are said to be ''underpriced'' because of their large initial returns. The dominant explanations of the underpricing phenomenon suggest that the initial returns should be earned by purchasers who buy shares in the initial offering rather than those who buy shares in the aftermarket. Since many shares experience a great deal of trading activity during their first day of trading, and since observers have noted that many purchasers almost immediately ''flip'' (i.e., resell) their shares, it is not obvious who gains from the underpricing of the IPOs. We resolve that issue by examining opening price data in contrast to the closing price data on which previous studies have been based. We examine 175 operating company IPOs and 54 closed-end fund IPOs over the two-year period from December 1988 through December 1990. We contrast the returns based on the offering price to the first day's closing price against the returns based on the offering price to the price of the first transaction of the day, and we also examine the intraday price on the first day of trades. We show that virtually all of the initial return due to the underpricing of IPOs occurs at the opening transaction. That result has a practical implication: it confirms that the benefits of underpricing accrue almost entirely to subscribers to the IPO. We show that, on average, 90% of the initial returns in common stock offerings are earned by the initial purchasers of the shares. After die opening trade, continued price movement during the first day of trades is (on average) not worth the cost of round-trip commissions, except perhaps for customers who enjoy unusually low transactions costs. In fact, the median first day's opening-to-close rate of return is exactly zero: fewer than one-half of all IPOs have positive returns on the first day following the initial transaction. A trader who bought the shares in the first transaction of the day would earn a zero rate of return or lose money (even before transactions costs) between the initial purchase and the closing trade on that same day in more than 50% of the IPOs in our sample. Some authors have studied the process of adjusting the price from a preliminary filing range to a final offer price and shown that it reveals new information about the initial returns in IPOs. Like earlier research on underpricing, the research on price adjustment has been based on using closing prices at the end of the first day's trading activity. We therefore also examine whether the information content of preliminary price adjustments is fully reflected by price at the opening transaction. We find that to be the case: The preliminary price adjustments are associated with initial returns as measured by the opening transaction, but they are not associated with the first day's intraday returns. Thus, we confirm the earlier research and show that the predictive power of preliminary price adjustments is exhausted by the opening trade. This paper does not explain the IPO phenomenon known as underpricing. However, it does provide evidence that once the shares of an IPO begin trading in the public marketplace, equilibrium prices are rapidly established in spite of the potentially wide variety of opinions and information sources that market participants may bold. The paper has a variety of implications for financial executives. For those contemplating initial issues of their firm's common stock, the empirical results provide evidence that those investors who purchase the shares in the primary offering will benefit from virtually all of the underpricing that occurs if the offer is initially underpriced. This result may appeal to the executive's sense of ''fair play'' since the investors in the primary offering are the ones who bear the greatest price uncertainty and who facilitate the success of die offering as a means of providing the company with additional funds for expansion or other corporate purposes. The paper also has implications for the executives in their role as investors for their personal investment account. The clear message of die paper is that, if they hope to benefit from the underpricing that they perceive in an IPO, they must participate in the primary offering itself. It is largely fruitless to buy the issue (in pursuit of gains from mispricing) in the aftermarket, even in the first transaction in the aftermarket.