What is your prediction?

Question

Acme Company just had a very successful IPO. Initial shares sold at a price far above their realistic value. The “buzz” on the streets is that this is one hot stock. Demand for the stock is high and rising. Is the price of Acme Company's stock likely to rise or fall? what is your prediction?

Answer 1

Your question is phrased in a very leading way ("price far above their realistic value", "one hot stock"), so I strongly suspect that your professor wants you to predict that Acme Comp. underperforms in the long run.

A classic study by Jay Ritter in the 1991 Journal of Finance indeed argues that IPOs tend to underperform in the long-run. Ritter writes: "The [empirically observed stock return] patterns are consistent with an initial public offering market in which (1) investors are periodically overoptimistic about the earnings potential of young growth companies, and (2) firms take advantage of these 'windows of opportunity.'" (http://ideas.repec.org/a/bla/jfinan/v46y...

Richard Carter, Frederick Dark and Ajai Singh find that the underperformance of IPO stocks relative to the market over a three-year holding period is less severe for IPOs handled by more prestigious underwriters (see http://dx.doi.org/10.1111/0022-1082.1046...

However, long-horizon security price performance is difficult to measure, and  studies by S.P. Kothari and Jerold B. Warner (Journal of Financial Economics, Volume 43, Issue 3, March 1997, Pages 301-339 - link below) as well as John Lyon, Brad Barber, and Chih-Ling Tsai (The Journal of Finance, Volume 54, Issue 1, 1999 - link below) point out methodological problems with IPO long-horizon return studies.

Whether IPOs systematically underperform is still a contested question in the finance literature.

Answer 2

go behind the scenes,look for law suits and potential law suits,acquisition of debt ,price to earnings ratio,etc,if it lives up to the hype then it should hold it's own or grow steadily  .........tom