Overpricing is measured as the difference between the offer or opening price for the IPO’s stock and its closing price after the first day of trading scaled by the offer price. When the opening price exceeds the closing price, the IPO is said to be overpriced. the closing price is assumed to be the equilibrium or “true” value of the stock.
In this case, the IPO firm will receive excess capital per share relative to the equilibrium value of the IPO’s stock (this is the opposite of underpricing where the difference is negative, i.e., the offer price is lower than the equilibrium price).
Since underpricing is often referred to as “money left on the table,” we may characterize overpricing as “money-put-in-the-coffers.” Let us now examine how overpricing may play out for the major players in the IPO launch.
We are assuming that bookbuilding is used and that the IPO firm is WeB-Genes, a pharmaceutical-boutique holding a patent on a hot genome-product called Kur-Y’all. Because of all the extremely positive scientific and clinical evidence, the FDA has fast-tracked Kur-Y’all.
For this reason, WeB-Genes has been actively courted by many of the major investment bankers (IBs). There are some possible reasons for overpricing where, by definition, the book building subscribers contribute an excess of funds to the IPO relative to the equilibrium price.
Usually it is because there is a paucity of real information and an excess of reality blurring exuberance and the investors in WeB-Genes get caught up in the hype and pay for it by accepting a stock price that is too high. This is essentially what happened in the mid-1990s relative to the dot.coms or what has been called the got.conned era.
Apropos to overpricing, according to the Financial Times: London “... one banker says: ‘Generally speaking, if a stock underperforms, it was because it was overpriced at the issue. It is a question of supply and demand. Sometimes you can’t get a quality level of institutional investors to support the stock in the after-market’.”
Let us also consider the effect of overpricing from the IB perspective. The IB earns more on an overpriced offer than on an underpriced offer since they receive a percentage of the gross proceeds raised by the IPO firm. So it may seem that the IB will have an economic interest in overpricing. But this is actually not the case.
Recall that in the bookbuilding process, the IB firm shops the IPO firm to potential investors. What keeps these potential investors interested in buying the IPOs is the fact that the IB usually offers them a bargain in that underpricing is the typical outcome.
The IB firm would never intentionally overprice an IPO to collect a higher fee at the expense of its valued client base. This would be considered either financial high treason or evidence that the IB does not know what they are doing. In either case, the result of repeated overpricing by the IB is the same: a book with a lot of empty pages.