How Do Underwriters Set Stock Prices?

by Cam Merritt, studioD

When a company goes public -- begins selling stock to outside investors -- it doesn't just pick a share price out of thin air. The stock's underwriter tries to set a price that will gain the company the most money while still guaranteeing that the initial investors, the ones taking the risk by buying the stock, will be rewarded with a profit.

Competing Influences

The first step for a company planning an IPO (initial public offering) is to hire an investment bank to manage the process. This bank, known as the lead underwriter, researches the market for the stock, lines up investors to buy into the IPO, and sets the share price. In setting the price, the underwriter has to balance competing interests. The company wants the price to be high, because it makes money only from the initial sale of the stock, not from any run-up in prices once the shares hit the open market. For that reason, the underwriter can't set the price too low. At the same time, the initial investors want to be assured that they will profit from the deal -- that their shares will rise in value after the IPO. For that reason, the underwriter can't set the price too high.

Indications of Interest

The lead underwriter starts by drawing up a prospectus, a highly detailed document outlining the company's current financial condition, its future prospects and its overall business plan. The underwriter distributes this prospectus to its investor clients and takes preliminary orders for shares. The "clients" here aren't individual investors, but rather institutions with billions of dollars in capital to invest, such as mutual funds, insurance companies and pension funds. The orders for shares, called "indications of interest," give the underwriter a sense of market demand for the stock, which will help it set the price. An indication of interest, however, is not a binding commitment to buy shares. The lead underwriter also assembles a "syndicate" of other investment banks to solicit interest from their own clients.

The Road Show

During the run-up to the IPO, the company's management team embarks on the "road show," a tour of major cities for personal meetings with big investors. At these private meetings, the team usually expands on the information in the prospectus. Prospectuses tend to accentuate the negative, dwelling on the threats to a company's profitability, to reduce the chances of lawsuits from investors who might allege that they were tricked into buying a bad stock. During the road show, however, the managers can be more upbeat. These sessions also allow investors to question the managers directly. If the road show goes well, the institutional investors will reaffirm their interest, which should help set a higher price for the stock. If the road show doesn't go as well, the price may have to be set lower. If the road show is a bomb, the company could postpone the IPO or even cancel it completely.

Setting the Price

The underwriter uses information from its research to set the "offering price." This is the price the initial investors pay for their shares directly from the company. Once those investors get their shares, they can sell them on the stock exchange where the newly public company is listed. There, the price of the stock is determined not by the underwriter, but by demand from the investing public. If the IPO was planned correctly, this "opening price" will be higher than the offering price, but not too much higher. The difference between the two is called the premium, and, according to CBS MarketWatch, underwriters generally shoot for a premium of 15 percent. In some cases, the premium ends up being much higher. The news media often portray such IPOs as raging successes, and they are -- for the initial investors. But a huge premium means the company that issued the stock probably didn't raise as much money from the IPO as it could have.

About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.

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