First Day Pop

The first day pop is perhaps the most watched statistic in the IPO market. A large pop — say a stock priced at $20 per share that closes at $30, a 50% gain — generates headlines and excitement. But for the issuing company, a massive pop is a mixed signal at best. It means the company sold shares for $20 that the market immediately valued at $30, leaving $10 per share in value that could have accrued to the company in the form of higher offering proceeds.

The phenomenon of systematic IPO underpricing has been documented by finance researchers since the 1970s. Professor Jay Ritter of the University of Florida has maintained extensive historical data showing that the average first-day return on U.S. IPOs has ranged from around 10% to over 70% in the late 1990s bubble period, with a long-run average of roughly 15% to 20%. Across thousands of IPOs, this represents an enormous aggregate transfer of wealth from issuing companies to the investors who receive allocations.

Several theories attempt to explain persistent underpricing. Winner's curse models argue that because some investors are better informed than others, the offering price must be low enough to attract uninformed investors who bear the risk of receiving allocations in bad deals. Signaling theory holds that high-quality companies deliberately underprice to establish a reputation that enables better terms in future equity offerings. Information extraction models suggest that underwriters underprice to compensate institutional investors who reveal truthful demand information during book building.

Not every IPO pops. Deals that are priced too aggressively relative to demand may open below their offering price, a scenario colloquially described as breaking issue or trading below water. High-profile examples include Facebook's 2012 IPO, which barely moved on its first day due to a pricing process that extracted maximum proceeds, and several other consumer technology IPOs that immediately traded below their offering price.

For retail investors, the first day pop is largely inaccessible unless they received an allocation at the offering price. Those who buy in the open market on the first day are typically paying a price that already incorporates some or all of the pop, meaning the expected forward returns are more modest.