Evaluation of IPO Pricing for Google Ltd Based on Financial Theories - Case Study Example

Corporate Finance - Evaluation of IPO pricing for Google Ltd based on financial theories Professor: Institution: City and State: Date: Contents 1 Introduction 3 Google’s IPO pricing at $85 per share in 2004 3 Benefits 5 Costs 5 Conclusion 6 References 7 Introduction Initial Public Offer (IPO) refers to the first time a corporation sells its shares to the public in an open market. Companies undertake IPO’s to raise capital for funding growth. However, many IPOs across the world are underpriced, an act typically referred to as “Leaving Money on the Table”. Under pricing IPO’s means both the firm and the shareholders are short-charged and get lesser monies than what they deserve. IPO’s can also be over priced; meaning that shares are sold at a price higher than the market rate making a company and its shareholders to get more than they deserve. The former scenario is very rare as majority of IPO’s are underpriced. Google Inc is an American multinational company that focuses on internet related products and services. Its sole mission is to organize global information by making it universally useful and easily accessible. Initially, Google was incorporated as a private company on 4th September 1998, but was later turned public through an IPO in 2004. Many people never understood whether the IPO share price was undervalued or overvalued. Therefore, this paper seeks to determine if Google’s IPO price at $85 per share was under priced or over priced and goes further to explain the benefits and costs associated with going public. Google’s IPO pricing at $85 per share in 2004 Even though information extraction theory posits that IPO under pricing seeks to attract uninformed investors to take part in an IPO, information about Google made members of the public and strategic investors’ to turnout overwhelmingly forcing issuers to issue shares on pro-rata basis. Shares were sold through auction mechanism, but following the efficient market theory it is the market that determined the share market price. In this respect, Google’s IPO share price fell below its market price on the first day of trading, but investors’ information about Google led to increased demand for its shares. Such information and increased demand contributed to rise of the market price. According to Chemmanur (2003), the IPO share price fell by over fifteen percent to the marker rate. The idea of setting such low prices was to substantially achieve higher net proceeds from the IPO and less share dilution. In line with signaling hypothesis theory, firms under price their IPO’s to allow investors make high profits from shares purchased (Lowry & Schwert, 2004). Therefore, Google idea to issue shares at $85 could have been intentional to allow investors purchase more shares. Certainly, the company was highly rated and therefore its shares could have traded more expensively than the offer price. This clearly indicates that the company wanted its shares to be as cheap as possible to allow all classes of investors to participate in the IPO. Google used auction process rather than the usual bookmaking process to determine IPO price. The auction price had a single market price and therefore, all bids above this price received shares at the auction price. However, considering the history of IPOs; Google’s IPO was very reasonable since it gave investors an opportunity to invest in the company despite being a highly rated company. Google reserved the right to set auction price below the market clearing price with intention of eliciting demand. The IPO price was well below the market clearing price. The effect of offering shares at $ 85 was over subscription which in turn led to restriction on the number of shares allocated to every bidder. In line with price-discovery model, investors upon discovery of under pricing tend to scramble for shares causing the issuer to issue on rationed basis. If Google had set the IPO price at par with market clearing price plus the allotment fee, the shares offered to subscribers could not have been rationed. According to Ritter and Welch (2002), share allotted were rationed based on pro-rata basis including those issued to small bidders. Initial under pricing of IPO’s seeks to set share prices below the market prices. Nevertheless, if Google had used prediction market to determine the IPO share price, things could have been completely different. Electronic Markets (EM) carried out two prediction studies to estimate market value for Google IPO on the first day of trading. Efficient market hypothesis states that shares will always trade at their fair market value and therefore, investors cannot purchase under priced or over priced shares. This theory contradicts the IPO share price considered to be too low by providing that as a perfect market, such shares would only trade at their right price. According to Benveniste and Spindt (2004), if markets could generate accurate predictions, then they could have saved Google from losing money from share under pricing. Google issued 19,605,052 shares at $ 85 per share collecting a total of $1.67 billion (Berg, Forsythe and Reitz, 2003). Had the same amount of shares been sold the following day, the opening price was $100.01 closing at $100.34 and therefore could have netted a total of $ 300 million in revenues. This under pricing affected not only the company, but also existing shareholders who sold 5,462,917 shares losing over $81 million relative to the closing price. According Ritter and Welch (2002), prospect theory posits that firms not only benefit from the IPO share price, but also increased volume of trading that takes place after the IPO. Therefore, based on the aforementioned, Google’s IPO shares were underpriced at $85 leading to oversubscription and eventual rationing which was done on pro-rata basis. The benefits and costs of Google going public Benefits Going public increases company’s share capital and also raises the value of company’s shares (Jenkinson & Ljungqvist, 2001). In addition, the company will in future gain access to capital markets when faced with financing needs. Previously, Google could only source capital from owners, but after going public, it can now float shares and get funding from members of the public. More importantly, a company debt to equity ratio improves following the IPO hence enabling it to negotiate more favourable loans from lenders. Even after offering shares through IPO, the management can also maintain a significant degree of control. In this respect, the shareholding floated for purchase by both strategic investors and members of the public must be less than fifty plus one percent. Even after Google went public, Larry Page and Sergey Brin remained the majority shareholders and main decision makers. Across the corporate circles, there is a certain allure when one is a director of a publicly listed company. More importantly, the company enjoys the opportunity to be publicly promoted. In this vein, publicly listed companies get wide publicity unlike those that are private. According to (Derrien and Womack, 2003) publicly trading companies have a good image and are more stable. Google presently attracts more publicity that it used to before going public. Costs There are numerous reasons why Google may not have wished to go public. Floating company shares to the public is an expensive and difficult undertaking involving accounting fee, legal fees among others. In addition, a company can lose huge amounts of money if the issue price was not correctly determined. For instance, Google recorded huge losses by under pricing its shares. The mechanism used to determine Google’s IPO share price was not accurate hence led to huge losses. By going public, the status of a company immediately changes. This is because; such a company is required by company’s Act to make its prospectus public. Information disclosed includes executive and management compensation and prior violations of stocks and securities exchange laws. Google had operated as a private company and disclosing such sensitive and highly confidential information could raise jitters within the management (Lowry & Schwert, 2004) For public companies, the management is separated from the owners of the company. In public companies, the management works for the interest of shareholders and therefore under pressure to increase shareholders net worth. Google has ever since been a successful company, but this does not isolate it from demands facing other publicly listed companies to maximize shareholders net worth. Conclusion Google is one of the highly rated and best performing companies in the information and technology sector. Its going public in 2004 attracted many investors. However, majority of them never understood whether the IPO share price of $85 was really an underpriced or overprice. IPO under pricing across the world continues to attract mixed reactions. Nevertheless, the theoretical aspects of this study confirm that under pricing an IPO is not only advantageous to the firm, but also to the shareholder in the long-term. Rock (1986) argues that it is not right to earn everything in the short-term, but it always pay when something is left for the investors to enjoy. In the light of high share demand, the investors can leave more money with the firm and therefore the firm due to increased share trading and therefore the firm stands to gain in the long-term. Therefore, IPO under pricing is not necessarily a bad approach of going public as there are associated gains emanating from “leaving money on the table. References Benveniste, M., and Spindt, P. 2004. How Investment Bankers Determine the Offer Price and Allocation of New Issues, Journal of Financial Economics, 24 (6), 343–362. Chemmanur, J. 2003. The Pricing of Initial Public Offerings: A Dynamic Model with Information Production, Journal of Finance, 48, 285-304. Derrien, F. and Womack, K.2003. Auctions versus book building and the control of under pricing in hot IPO markets. Review of Financial Studies, 16(5), 31-61. Jenkinson, T. and Ljungqvist, A. 2001. Going Public: The Theory and Evidence on How Companies Raise Equity Finance, 2nd ed. Oxford, Oxford Press. Lowry, M., and Schwert, W. 2004. Is the IPO pricing process efficient? Review of Financial Studies, 71 (1), 3-26. Ritter, R. and Welch, I. 2002. A Review of IPO Activity, Pricing, and Allocations. Journal of Finance, 57 (15), 1795-1828. Rock, K. 1986. Why New Issues are underpriced. Journal of Financial Economics, 15 (3), 187– 212. Read More