In stock markets, numbers speak louder than words. Whether it is quarterly results of companies or price discovery mechanisms in an initial public offering (IPO), numbers are our trusted signposts. But numbers don’t fall from the sky. There are well-known price discovery mechanisms in case of an IPO. Our friend Johnny thinks that one should clearly understand these mechanisms before investing in IPOs. So let’s try to understand how the book-building price discovery method is different from the fixed-price method.
Johnny: How is the price discovered during IPOs?
Jinny: Well, discovery of price in an IPO is both a science and an art. The issuer companies have two options for fixing the price. They can either fix the price themselves or they can let the investors determine it. The first method, in which the company itself fixes the price, is known as the fixed-price method and the second, in which investors determine the price, is known as the book-building method. It is important to keep in mind that even in the fixed-price method, the prices are not determined randomly and the company has to disclose all the quantitative and qualitative factors that justify the fixed price.
But the fixed-price method has one drawback. It does not take into account investor demand into price discovery. If you want to sell a piece of gold at its intrinsic value but there is no demand in the market, your piece of gold will not be able to fetch that price. Fixed-price issues also face a similar problem. The issuers arrive at the fixed price after taking into consideration the reasonable value of their company but if there is no demand in the market, the shares will fail to generate subscription. In the opposite scenario, if the demand in the market is high, the price fixed by the issuer may not reflect the true market value and the shares may get sold at a low price. To overcome these kinds of problems, issuers use the book-building method. It helps in matching the price of shares with the demand.
Illustration: Jayachandran/ Mint
Johnny: How does the book-building method work?
Jinny: In the book-building method, the issuers indicate either a floor price or a price band within which the investors can place their bids. For executing the whole process, the issuers appoint the lead merchant banker as a book runner. The book runner appoints syndicate members who collect bids from investors. Both retail and institutional investors can take part in the bid. The bids received from investors are recorded in a book in electronic form. The book runner, in consultation with the issuer company, evaluates the bids and decides the final price, which is also known as the cut-off price. The cut-off price is the price at which the demand for the shares meets the price. In case your bid is below the cut-off price, you will not receive any allotment.
However, you can avoid this situation by submitting your bid without indicating any price. You have to simply indicate in your bid that you are ready to accept the offer of shares at whatever cut-off price the company fixes in the book-building process. This option is available only to retail investors and most of them submit their bid at the cut-off price.
Johnny: That’s interesting, Jinny. If all investors start submitting their bid at the cut-off price, the price discovery would become a discovery without surprise.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at email@example.com.