Retail Investor Attention and IPO Valuation

• Published date: 01 September 2017
• Author: Shantaram P. Hegde,Amedeo De Cesari,Hugh M. J. Colaco
• Date: 01 September 2017
• DOI: http://doi.org/10.1111/eufm.12113

Retail Investor Attention and IPO

Valuation

Hugh M. J. Colaco

Aston Business School, Birmingham B4 7ET, UK

E-mail: h.colaco@aston.ac.uk

Amedeo De Cesari

Alliance Manchester Business School, Manchester M15 6PB, UK

E-mail: amedeo.decesari@manchester.ac.uk

Shantaram P. Hegde

University of Connecticut, Storrs, CT 06269, USA

E-mail: shegde@business.uconn.edu

Abstract

Given restrictions placed on communication with prospective investors, retail

investor attention can help firms/underwriters with the task of initially valuing an

IPO. Using Google search volume to proxy for retail investor attention, we find

that the presence of and an increase in retail attention following initial filing but

prior to initial pricing are positively related to initial valuations. Our results are

robust to alternative matching methods to identify our matched sample of non-IPO

firms and to including several controls for institutional demand. We conclude that

retail investor attention plays a critical role in the early stages of IPO valuation.

Keywords: initial public offering, equity valuation, retail investor, investor

attention

JEL classification:G30,G32

1. Introduction

IPO valuation is challenging because of limited firm history and lack of presence in the

capital markets. While the offer price has the advantage of reflecting institutional

We thank three anonymous referees, John Doukas (the Editor), Tim Jenkinson, Robert

Kieschnick, Jay Ritter, and participants at the 2013 European Financial Management

Association meetings (University of Reading, UK), 2013 Financial Management

Association meetings (Chicago, USA), 2013 India Finance Conference (Indian Institute

of Management, Ahmedabad, India), and 2014 Behavioural Finance Working Group

Conference (Queen Mary University of London, UK) for useful comments.

European Financial Management, Vol. 23, No. 4, 2017, 691–727

doi: 10.1111/eufm.12113

© 2017 John Wiley & Sons, Ltd.

demand for the IPO, the initial valuation is at a significant disadvantage since the

roadshow typically occurs later.

1

Moreover, restrictions are placed on communication

between issuers/underwriters and prospective (mostly institutional) investors prior to

setting the initial price range. In this environment, firms and underwriters may be

dependent on other sources of information to initially value an IPO.

2

Retail investor

attention, a precursor of retail demand for shares, may be one such source. For example,

Demos and Dembosky (2012) report that unusually strong demand from retail investors

was one factor influencing the upward valuation of Facebook, Inc.’s IPO price in 2012.

The objective of this paper is to examine the influence of retail investor attention on

initial IPO valuation.

The importance of initial valuation to firms and underwriters is highlighted in Hanley

and Hoberg (2010, p. 2,826), who argue that significant resources are expended by a firm

and its underwriters and legal counsel to acquire information about the IPO, which

results in a more precise initial valuation relative to the final valuation; as a result, the

firm’s dependence on bookbuilding is reduced. The implication in Hanley and Hoberg

(2010) is that institutional interest is not available before the filing of the initial price

range. Furthermore, Kim and Ritter (1999, p. 411) posit that accounting information and

comparable firm multiples alone are not sufficient to ensure accurate pricing when

determining the initial price range. Rather, the market’s demand for the IPO helps to

improve pricing accuracy.

Prior to the passage of the Jumpstart Our Business Startups (JOBS) Act in 2012 in the

United States (US), Section 5 of the Securities Act of 1933 did not allow issuers and

underwriters to communicatewith investors before the filing of a preliminary registration

statement. Moreover, Rule 15c2-8 of the Securities Exchange Act of 1934 imposed

restrictions on issuers and underwriters that preventedthem from soliciting offers and

indications of interestfrom investors before the filing of a prospectus containingan initial

price range(Practical Law, 2014). As a result, US firms and underwritershave been unable

to engage in oral and written communication to a significant extent with prospective

investorsbefore the initial price range is filed (Latham and Watkins,2014). Several studies

documentthat institutional investor demand is not officiallyavailable when the initial price

range is set (Hanley,1993, pp. 231–232; Ljungqvist and Wilhelm,2002, p. 178; Wang and

Yung, 2011, p. 302; Chuluun, 2015, footnote 7).

In this restricted information environment, retail investor attention may contain

valuable clues about latent investor demand for the IPO that could help firms and

1

The initial valuation typically occurs in the form of a price range. The midpoint of the initial

price range (i.e., average of high and low prices) is used as an unbiased estimator of final

valuation (offer price) by many studies, including Hanley (1993), Loughran and Ritter

(2002), and Bradley and Jordan (2002). However, Lowry and Schwert (2004) find that public

information is not fully incorporated into the initial price range although the economic

significance is small. Many studies focus on valuation based on the offer price (e.g.,

Purnanandam and Swaminathan, 2004; Houston et al., 2006).

2

Given that valuing an IPO is an inherently complex activity that is more of an art than a

science, underwriters generally rely on a wide set of variables to assess market conditions and

investor demand for an issue (McCarthy, 1999). For instance, Internet IPOs are sometimes

valued using criteria such as web traffic, number of page views per user, and number of

engaged shoppers (Rueda, 2001).

© 2017 John Wiley & Sons, Ltd.

692 Hugh M. J. Colaco, Amedeo De Cesari and Shantaram P. Hegde

underwriters initiallyvalue an IPO. Retail investors areallocated a reasonably large block

of IPO shares.

3

Furthermore, Barber and Odean (2008) posit that retail attention is

importantbecause it may be a precursor of retail demand for shares inthe aftermarket. As a

result, incorporating retailattention could lead to more appropriate valuations for newly

public firms and reduce the need for underwriters to engage in costly price stabilisation

activities when tradingbegins (Chowdhry and Nanda, 1996). The attention paidby retail

investors to a going-public firm may reflect the intrinsic quality of the firm’s IPO and

convey genuine information that the firm and its underwriters can use when setting the

firm’s IPO valuation. At the sametime, even if retail attention is influenced by investors’

behavioural biases, theresulting irrational retail investor demand couldstill be taken into

account by rational firms and underwriters in the IPO valuation process.

Based on a sample of 185 US IPOs from 2004 to 2007, Da et al. (2011) find a

significant upward trend in Google’s search volume index (SVI) a proxy for retail

investor attention

4

beginning two to three weeks before the IPO week, followed by a

significant jump in SVI during the IPO week, indicating an increase in retail attention

towards the stock.

5

The SVI, however, reverts to its pre-IPO level two to three weeks

after the IPO, an indication that retail attention is not permanent.

We examine the relationship between retail investor attention (proxied by SVI) and

initial IPO valuation as measured by Price-to-Sales,Price-to-Assets, and Price-to-

EBITDA. Each of the three valuation measures is captured for an IPO firm relative to that

of a matched firm. We are specifically interested in examining how the presence of and

change in retail attention following the initial filing (S-1, or equivalent) are related to the

initial valuation, which is typically presented for the first time in a later amended filing

(S-1/A, or equivalent) with the Securities and Exchange Commission (SEC).

6

The initial

3

Aggarwal et al. (2002) find that institutional investors are allocated a median of around

three-quarters of the shares offered in an IPO, implying that retail investors get the remaining

one-quarter. More recently, Demos and Light (2013) state that typically less than a third of

IPO shares are set aside for retail investors.

4

Using retail order execution from SEC Rule 11Ac1-5 (Dash-5) reports, Da et al. (2011) find

a strong link between changes in SVI and retail investor trading. Furthermore, this link is

stronger for market centres that attract less sophisticated individual investors. Other recent

papers that rely on this proxy for attention are Doukas et al. (2016), Dimpfland Jank (2016),

Vozlyublennaia (2014), Bae and Wang (2012), and Drake et al. (2012).

5

We are not claiming that Google’s SVI is the only proxy for retail attention or that this proxy

is used by issuers and underwriters and is available to them in a timely way to price an IPO.

Retail attention could be estimated in alternative ways, for instance, by using information on

informal inquiries from retail customers of the underwriter, on the customer base of the issuer

(e.g., number of customers, customer loyalty and satisfaction, wealth of the average

customer, and likelihood that the average customer trades stock), and on web traffic on the

issuer’s website. It is likely that Google’s SVI is correlated with alternative measures of retail

attention that issuers and underwriters may use. If not, we would not be able to report

significant findings in our study.

6

To clarify terminology used henceforth, the date on which the initial filing is filed with the

SEC is referred to as the ‘filing date’. Similarly, the date on which the initial valuation (or

initial pricing) is filed with the SEC is referred to as the ‘pricing date’.By‘equivalent’,we

mean other filing types (e.g., SB-2 and SB-2/A) that satisfy our screening criteria.

© 2017 John Wiley & Sons, Ltd.

Retail Investor Attention and IPO Valuation693