FME102: Behavioral Finance - IPO Decision

Long-term Reversals: Winner-Loser Effect

• Extreme past losers tend to outperform the market, while extreme past winners tend to underperform the market.
• Behaviorists attribute this phenomenon to representativeness, which leads to extrapolation bias in respect to prior earnings.
• Investors overreact to stocks that have been past losers, causing them to become undervalued, and overreact to past winners, causing them to become overvalued.

Momentum: Short-Term Continuation

• Recent losers tend to underperform the market, while recent winners tend to outperform the market.
• Underreaction and overreaction occur due to the percentage change in market price being too small or too large in response to an event.

Post-Earnings-Announcement Drift

• Analysts forecast earnings, and when a firm's earnings exceed or fall below the consensus analyst forecast, it is a positive or negative surprise.
• Empirically, stock prices do not adjust immediately to earnings surprises, instead exhibiting drift.

Arbitrage

• Arbitrage is the process of exploiting mispricing, buying low and selling high.
• The efficient market perspective relies on arbitrage, where smart investors quickly take advantage of mispricing caused by irrational investors, rendering the mispricing small and temporary.

To IPO or Not to IPO?

• IPO decisions take place against the backdrop of three phenomena: hot issue market, initial underpricing, and long-term underperformance.
• Hot issue market refers to a high demand for new issues.
• Initial underpricing occurs when the offer price is too low, resulting in a large first-day price pop.
• Long-term underperformance occurs when new issues earn lower returns than stocks with comparable characteristics.

IPO Decision Dilemma

• Executives face a dilemma: maximizing market value in the short-term by going IPO in a hot issue market and paying for all-star analyst coverage through initial underpricing, but potentially exploiting excessive optimism, which may lead to long-term underperformance.
• Managers should consider maximizing long-term value, which corresponds to the conventional approach based on NPV, and discount rates used for the long-term should be based on the single-factor CAPM approach.

Forecasting Biases

• Managers' forecasts of cash flow, the market risk premium, and risk are subject to systematic bias.
• Biased forecasts can affect the accuracy of NPV calculations.

In a hot issue market, should a privately held firm move up its plans to go public and take advantage of the market conditions? This quiz assesses your understanding of IPO decisions and behavioral finance concepts.