Corporate Behavioural Finance - Case Study Example

Behavioral Finance Introduction Initial Public Offer refers to the sale of stock for the first time to the public by a private company. The company’s shares are issued to expand the capital base of the issuing company. The issuing company is often small and young company that wants to grow. In cases where IPOs are issued by large private companies, the main aim is to trade publicly. Companies issuing IPOs obtain assistance of underwriting institutions. The underwriting firms play a vital role of determining the security to issue pricing of the IPOs and their appropriate time to market IPOs (Hersh 2). During the process of initial public offer, biases may arise ranging from the issuing firm management, investors and analysts. If this biasness is unconsidered, it may have adverse effects on the firms share market price. Pricing is a key factor to consider when issuing IPOS. Mostly, firms under-price the shares and offer it with 10-15% less the face value. This allows the companys management to see the growth of the share price in the stock market and ensure that the investors fully subscribe to the issued share. However, in a situation where IPOs are overpriced, it is likely that the share issued may not be fully subscribed by the investors (Hersh 2). Analyst Biases In regard to Palm IPO, there was a conflict of interest from the analyst point of view. This can be seen from his point of argument that the palm share was outperformed and cheap. Barely 6 months from his analysis, Palm shares reported a down ward trend to trade at $21. The analyst has superior knowledge of the Palm share performance in the market hence influences the investors (mostly bulls) to buy the palm share of which they expect to have high returns. The analyst in this case is serving the client interest (the Palm Company) to market its stock since they are in the same line of business, and his compensation is coming from this part of the business. Investors Biases Investors over reaction bias on anticipation of Palm IPO and the hype that surrounded the IPO cause the overreaction. The under-pricing phenomenon by the underwriter made investors have a lot of confidence. The excessive optimism by the investors led to price leaps when the trading opened. This behavioral bias led to low returns in the later period. This can be evidenced in the Palm case; investors who thought Palm was highly overvalued at the time could not find shares to borrow to short the stock and subsequently set the price of Palm IPO (Hersh 2). The information provided by both the management and analysts misled the investors to view the market as bullish, but they established it to be bearish later. This led to loss of money by the investors through loss of share value and dividends payable. Management Bias The management bias came in when the Palm management and the investment bank did not determine the Par value of the Palm stock. Their offering price was based on settlement between the two parties. From the market trend, this can be regarded as overpricing of the share since the face value of the share was less than $38 that offered in the IPO. In most cases, the initial price of firm going public is underpriced, which was not the case with the palm IPO as established later in the stock. The Market price of the stock underperforms the stock index, and this did not turn out to be the case since in the first day since the price galloped up to $165. Another management bias is on the 3com management to issue 6% Palm to the public and retain the 94%. This means than it still holds more than the 51 of the shares hence the ownership of Palm cannot be transferred to any other person despite him/her buying most of the shares (Hersh 2). Palms Price on First Trading Day From the behavioral finance perspective, investment banks information advantage can be used to underprice the issue. Since the 3com market share was a bear, the underwriter knew that oversubscription could be guaranteed on IPO, and this would increase the attractiveness of Palm. As a result, the palm management and the underwriter had an incentive to underprice the IPO to ensure that investors fully subscribed to the Palm IPO and may have wanted more. If this could not have happened, the reputation of Palm and that of 3com would be put in jeopardy. In this case, Palm Management is taking advantage of the market inefficiency when raising capital by issuing shares through IPO because of controversial notion that investors are rational, and the market is efficient. Behavioral biases explain the low returns during the first few years after IPO. Pessimistic investors value below fundamental value leading to under-pricing. Another reason for Palm to underprice in IPO was as a marketing event. Buyers and Management of Palm wanted to associate the IPO success with the first day return. In this case, Palm and Its investors saw significant price growth in their underpriced shares (Hersh 3). Following the first day trend of the Palm share trading in the stock market, it is evident there was abnormal rise of the offering price whether the IPO Price was over the price or under the price. This abnormal rise in the first day price resulted from over performing stock index, which had an enormous impact on the Palm share price. The price later depleted to $0.60 in the later period; this shows a remarkably large discrepancy in the uninformed face value of the Palm Share. The 6% 3com issue to the public as Palm that later generated a value greater than the mother company is a clear evident that the price offered in the IPO was overvalued (Madura 80). The settling of the share market price at $0.60, eleven months after IPO, can be regarded as a clear indication that the Palm’s IPO could be considered as overpriced. Paul Sagawa Assessment on Palm Paul Sagawa, who works a wireless telecommunications analyst at the Sanford Bernstein, indicated Palm’s shares as “outperform,” and called it his favorite stock, and he indicated it as cheap because of its immense upside potential. However, a Journal article from the Wall Street indicated that Sagawa’s enthusiasm for the stock was boosted after the purchase of a Palm for his wife. Sagawa watched his wife use it to keep the schedule of her social appointments and phone numbers. In his analysis, Paul anticipated a bullish market for Palms stock. In this scenario, the Investors are encouraged to buy Palm shares so as to earn higher returns in the future. His description of the share as cheap tends to disregard the initial notion by the 3com management and investors that the market was bearish. Therefore, the disintegration of the Palm from 3com was deemed to be an ultimate marketing event that came in with higher returns (Hersh 3). One can describe Paul Sagawa as an independent analyst. Study shows that investors tend to believe a private analyst more than the institutional analyst. In this case, Paul led by example by even using Palm’s product to win the investors’ confidence. On the other hand, the Paul’s analysis could have a negative impact on the investors. The positive response to his analysis led to over confidence in the investors, hence overreaction to the purchase of Palms shares. The overreaction to the purchase of shares led to higher price of the share, which later translated to the low demand. This led to drastic downward fall of the price to far below the share face value (Hersh 3). Works Cited Hersh, Shefrin. Corporate Behavioural Finance. London: McGraw Hill, 2005. Print. Read More