Book Building versus Fixed Price: Methods of Price Discovery

When we think of why share prices are what they are, the first thing that naturally comes to mind is the demand and supply play – investors’ sentiment.

When we think of why share prices are what they are, the first thing that naturally comes to mind is the demand and supply play – investors’ sentiment. While this is true, demand and supply is only useful when the stock is already out for the market to see. However, when it is just being introduced to the market, the pricing of the stock is determined in a different ways. There are two main price discovery mechanisms used in the stock markets when it comes with pricing securities for the first time and they include fixed pricing system and book building. Here’s how they work:

Fixed pricing

When a company comes to the market for the first time, one of the easiest ways to set the first price is simply to just do it. The way the fixed price system works is that as the company goes public, it determines a fixed price that it will offer its shares to investors. It, however, does not disclose demand. Investors are made aware of the share price as predetermined by the company, but demand is only determined after the issue and investors that want to be a part of the initial public offer, simply need to pay for the shares at the point of applying. The fixed pricing system is straight forward and it is the most common method used.

Book Building

The other common method of setting the price of an IPO is what is known as “Book Building.” Book building is the process of determining the initial price of a security for the first time. The way it works is that investors are provided with a price range and asked to bid. An underwriter which is normally an investment bank, ‘builds a book’ by inviting institutional investors to submit bids detailing the number of shares they want as well as the price(s) they would be willing to pay for the shares. This is a price discovery process that involves obtaining data on investor demand for the stock of a company before the company determines an issue price, as opposed to the fixed pricing system that simply sets a price. One of the benefits of this is that as opposed to the fixed price method where the investors only get what the company offers, book building satisfies the desires of the investor as well as the company. It is, thus, very efficient. An example of a company that used this is Airtel when it was getting quoted on the Nigerian Stock Exchange (NSE) last year.

Note that with an IPO, there will always be the risk of the stock either being set too high, thus making it overpriced or being set lower than par, making it undervalued. However, the fundamentals of any company will always reveal the company’s true position.

Written by Lawretta Egba.