Are IPO price pops signs of market irrationality?

Maybe not, or so I argue in my latest Bloomberg column.  As you may know, the first day price pops for Airbnb and Doordash were considerable, Airbnb more than doubling in its first day of trading: Here is one excerpt:

On IPO day, each prospective buyer is wondering what the shares will be worth, and to a great extent looking to the judgment of the other investors. A buyer might start the day willing to pay $60 a share, but upon seeing that many others are willing to pay more, maybe she will, too. It is like Keynes’s famed “beauty contest,” where investors are guessing as much about each other as about the company.

In such a setting, prices can rise or fall extremely quickly, as the very process of trading reveals information about the stock’s value. That in turn makes it possible for the share price to soar on the first day of trading, creating the “pop.”

Now consider this scenario from the perspective of the issuing investment bank. If it sets the IPO price too high, it may set off a downward spiral of negative enthusiasm. Traders will see that most of the other traders think it is overpriced, leading to a plunge.

It’s all a bit like a restaurant on a Saturday night. If the place is seen as “cool” — whether because of its food and service (the product), its setting (the physical asset) or its ambience (the brand) — there will be a line out the door. Otherwise it will be fairly empty. Furthermore, the presence of a line will draw continued interest over time. It is hard or maybe even impossible to set prices so that every table is filled yet there is no line. To deploy some technical language, the demand curve may be discontinuous.

In this position, the IPO issuer likely will set the initial price too low — leading to a “line,” excess demand, and a big run-up in price on the first day. If the price is super-high in the first place, the market mood would be nervousness rather than eagerness, and most investors wouldn’t be able to see the surges in demand visible in lower price ranges.

Keep in mind that this surge in buying interest only has to make investors modestly more enthusiastic about the quality of the firm to generate a potentially big increase in final valuation.

All this said, in the current case, there is the question of why the initial prices were so low. Several theories present themselves: The markets for DoorDash and Airbnb might be more “winner take all” than usual. The value of those companies might be more closely linked to the value of their intangible assets. Or maybe the future of online services might be especially hard to predict in the midst of a pandemic, thus inducing larger bandwagon effects.

It is worth noting that differing auction systems for IPOs have not produced obviously superior results.


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