An IPO ‘Pop’ Shows Wall Street Is Working

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If an initial public offering has a “pop” on opening day, does that mean somebody was ripped off? Did the company leave money on the table by allowing its investment bank to offer the shares at too low a price?

Maybe. But consider whether there might be a rational explanation for this pop phenomenon.

This question is a perennial, but it has gained fresh attention with last week’s IPOs for DoorDash and Airbnb and today’s for Wish, which is already oversubscribed. DoorDash and Airbnb had huge “pops,” with the latter opening at more than double its IPO price, a record for a large U.S. stock. That seems crazy, and so it’s easy to think the initial price was too low, either through incompetence (the underwriters just didn’t do their research) or corruption (cheap shares were handed out to friends of the bank).

Nonetheless, there is such a thing as a rational IPO price pop. It represents a kind of feedback loop, with buyers needing to see the enthusiasm of the other buyers to be interested.

To walk through the logic in more detail: New firms, especially in the rapidly changing technology sector, are especially hard to value. Typically their value stems from their brand, talent and software capabilities, rather than more easily measured physical assets such as factories.

In addition, small differences in quality can mean big differences in revenue — and in valuation. Take DoorDash, which faced tough competition from Seamless and UberEats in food delivery. The company flourished by using data skillfully, offering better selection and quality, and focusing on the suburbs. It went from a distant third to a major player in the market.

If the team at DoorDash were, say, 20% less skilled than it is, the counterfactual is not that the company would be worth 20% less. It’s that it would not exist. That’s one consequence of a “winner(s) take all” market.

On IPO day, each prospective buyer is wondering what the shares will be worth, and to a great extent looking to the judgment of the other investors. A buyer might start the day willing to pay $60 a share, but upon seeing that many others are willing to pay more, maybe she will, too. It is like Keynes’s famed “beauty contest,” where investors are guessing as much about each other as about the company.

In such a setting, prices can rise or fall extremely quickly, as the very process of trading reveals information about the stock’s value. That in turn makes it possible for the share price to soar on the first day of trading, creating the “pop.”

Now consider this scenario from the perspective of the issuing investment bank. If it sets the IPO price too high, it may set off a downward spiral of negative enthusiasm. Traders will see that most of the other traders think it is overpriced, leading to a plunge.

It’s all a bit like a restaurant on a Saturday night. If the place is seen as “cool” — whether because of its food and service (the product), its setting (the physical asset) or its ambience (the brand) — there will be a line out the door. Otherwise it will be fairly empty. Furthermore, the presence of a line will draw continued interest over time. It is hard or maybe even impossible to set prices so that every table is filled yet there is no line. To deploy some technical language, the demand curve may be discontinuous.

In this position, the IPO issuer likely will set the initial price too low — leading to a “line,” excess demand, and a big run-up in price on the first day. If the price is super-high in the first place, the market mood would be nervousness rather than eagerness, and most investors wouldn’t be able to see the surges in demand visible in lower price ranges.

Keep in mind that this surge in buying interest only has to make investors modestly more enthusiastic about the quality of the firm to generate a potentially big increase in final valuation.

All this said, in the current case, there is the question of why the initial prices were so low. Several theories present themselves: The markets for DoorDash and Airbnb might be more “winner take all” than usual. The value of those companies might be more closely linked to the value of their intangible assets. Or maybe the future of online services might be especially hard to predict in the midst of a pandemic, thus inducing larger bandwagon effects.

It is certainly possible that there is something funny or illegitimate with the overall IPO process. But what happened this last week does not defy a basic understanding of economics. This might just be what an unpredictable world of extreme enthusiasms looks like.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. His books include "Big Business: A Love Letter to an American Anti-Hero."

©2020 Bloomberg L.P.

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