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Searching for Google’s Value:

Using Prediction Markets to Forecast Market Capitalization Prior to an Initial Public Offering

1. Introduction

Underpricing of initial public offerings (IPOs) is a well-documented phenomenon. Jenkinson and

Ljunqvist (2001, p.27) report average underpricing of 15.3% for U.S. IPOs.1 Smart and Zutter (2003),

restricting their examination to IPOs between 1990 and 1998 for companies with dual-class shares, find a

similar, though slightly lower, rate (11.9% on average). Causes of underpricing have been modeled in a

variety of ways. Some examples include underpricing resulting from (1) information asymmetries across

investors (e.g., Rock, 1986), (2) information asymmetries between issuers and investors that are overcome

with large payments to investors (e.g., Chemmanur, 1993, Benveniste and Spindt, 1989, and Sherman and

Titman, 2002), (3) future benefits to underpricing (in particular, Welch, 1989, discusses underpricing to

drive out bad firms and, as a result, attain benefits in future secondary offerings; Booth and Chua, 1996,

discuss future benefits arising from ownership dispersion; and Tinic, 1988, and Hughes and Thakor,

1992, discuss future benefits in the form of reduced potential future legal liabilities).2

Our study provides new evidence about IPO underpricing. We use small-scale, real-money

markets designed to predict Google’s post-IPO capitalization. These IPO prediction markets are valuable

for two reasons. First, IPO prediction markets can inform theory. In the case of Google, the combination

of the prediction market and Google’s unique auction mechanism provide particularly compelling

evidence on theory. Second, IPO prediction markets can have a practical application in setting optimal

IPO prices.



Similar underpricing is found in Ritter and Welch (2002), who document an average 18.8% first day return (15.8% underpricing) in a sample of 6,249 U.S. firms between 1980 and 2001. Loughran and Ritter (2004) document that underpricing appears to change over time with average underpricing of 7% in the 1980s, 15% in the period 1990-1998, 65% in 1999-2000 (the Internet bubble), and 12% in 2001-2003. We note that there are other types of theories. For example, Loughran and Ritter (2002) discuss a role for prospect theory and Khanna, Noe, and Sonti (2005) discuss the role of labor market shortages for investment bankers. We do not discuss these models because our evidence does not address them.


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