Executive Summary
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When a company goes public, the issuer’s intermediating investment bank (aka the underwriter, bookrunner, or lead manager) expends efforts and resources to discover the price at which the firm’s shares can be sold.
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Buy-side clients also expend effort and resources to value the firm. The market price will be a weighted average of the many resulting value estimates.
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To discover the price at which the issue can be sold, the issuer helps buy-side clients with their analysis by providing a prospectus and meeting with their analysts during road show meetings.
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To extract newly produced information from the market, the issuing team asks selected buy-side clients for their indications of their interest.
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Investment banks compensate buy-side clients for their costly analysis by setting the price at a discount from the expected market price.
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In addition, investment banks allocate more shares to those buy-side clients who are more helpful in the price discovery exercise. Because of the repeated interaction between banks and their clients, free riding is curtailed, and price discovery is optimized.
Price Discovery
The most important, yet most difficult, part of the initial public offering (IPO) process is setting the offer price. In an IPO, the issuer, aided by an intermediating investment bank, plans to sell a relatively large number of shares of common stock in which there is at that point no market. However, they know that soon after the IPO process the secondary market will impute all the information in the market in an efficient manner. Investors who believe the price to be too high will sell; investors who believe the price to be too low will buy. The key outcome of this competitive trading is the market price of the stock.
Naturally, the issuing team (the issuer and its investment bank would like to know the market price in advance. If they had a crystal ball, they would set the price at a small discount (say 3%) to the future market price, so as to generate sufficient interest from buy-side clients, and place the issue. In fact this is exactly what issuers do when they sell securities which already have a market price. Unfortunately, there is no secondary market for IPO shares, and neither are there crystal balls.
To estimate the market price as best as they can, issuers and their advisers conduct a costly analysis to estimate the value of the firm. We call this process price discovery.
Note that not only do the issuer and its investment bank analyze the firm. Prospective investors also conduct costly analysis to predict the future market price. Naturally, a good estimate of the future market price gives them a substantial advantage in their dealings with the issuer: If they have strong indications that the offer price is set too high, they stay away from the offering. If they believe the price to be below the future market price, they sign up for IPO shares enthusiastically.
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