MSG Team's other articles

12524 Sources of Revenue: Broadcasting Rights

The consistent generation of revenue is important for the success of any sports league. If the organizers of any of these leagues have to spend a large amount of time and resources to collect revenues, then they will not be able to focus on organizing the game. This is where the broadcasting rights come into […]

12669 Cash Ratio – Meaning, Formula and Assumptions

The cash ratio is limited in its usefulness to investors and financial analysts. It is the least popular of the liquidity ratios and is used only when the company under question is under absolute duress. Only in desperate circumstances do situations arise where the company is not able to meet its short term obligations by […]

10939 Relationship Between Types of Costs and Inventory

The relationship between when cash is spent and when it is recognized as an expense is fairly complex in job order costing. Costs flow through the inventory accounts and finally become an expense when the sale is complete. This relationship and the complexities that arise have been tracked in this article. Outlay vs Expenditure To […]

10400 Multi-Currency Accounts

In the globalized world of today, it is common for a business to go international. Almost any company which has a sizeable turnover has to deal with suppliers and vendors from across the globe. It is true that businesses receive the benefits of such expansion. However, there are also certain costs which are associated with […]

10583 Pension Funds and Income Redistribution

The purpose of pension funds is to ensure that the wealth created by an individual is invested and distributed in such a way that they can afford to maintain their standard of living throughout their lifetime. Pension funds have become a very important tool for retirement planning. An average pensioner plans to survive almost twenty […]

Search with tags

  • No tags available.

It is often believed that the role of the investment banker is to sell the company for the highest price. The conventional belief is that the higher the price, the more successful the issue has been. However, over the years, the management of issuing companies, as well as investment bankers, have painfully discovered that a higher price post an IPO does not necessarily mean that a company is doing well. Instead, a higher price post an IPO can lead to a wide variety of problems. Some of these problems have been mentioned in this article.

  1. Sell-Off and Over Correction: The insiders of a company often know its true worth. Once the company does go public, this information is available to informed investors as well.

    If the informed investors find that the stock is grossly overvalued and there is very little possibility that the fundamental value of the stock will ever catch up to what is currently being offered at the market, they will start selling.

    We have already studied in previous articles that institutional, as well as informed investors, tend to have large holdings of the stock of major companies. If they start selling the stock, then the market will be flooded with stock for sale. The end result would be an overcorrection, which would lead the price to crash.

    In short, the overvaluation of a share is a temporary phenomenon that would sooner or later become the cause of a crash.

  2. Unrealistic Expectations: If the investors in the company start believing the hype, i.e., if they also start believing that the overvaluation of the company is actually the real valuation, then another set of problems starts appearing.

    The investors start expecting a higher standard of returns from the companies. This higher expectation is seen in the form of pressure that is built around the quarterly results.

    The company would be forced to undertake riskier projects in order to satisfy the need for a higher IRR and cash flow, which would ultimately justify the higher valuation. Over time, it is likely that the risky projects being undertaken would do more harm than good.

  3. Leads to Fraud: In many cases, the management of overvalued companies are not able to obtain higher returns even from high-risk projects. This is when the pressure to keep the numbers up forces them to start following questionable accounting practices. This ultimately leads to fraud and, in many cases, has led to the complete bankruptcy of the overvalued company.

    Instead of fudging numbers in order to live up to the hype, these companies would have been better off had they simply admitted the overvaluation and allowed the stock to settle at a fairly valued price.

    Almost all companies which end up committing fraud start doing it just to meet the high expectations set up by the investors as a result of the overvaluation. Companies like Enron, WorldCom, and Waste Management are testimony to this face!

  4. Poorly Designed Acquisitions: There are some companies that try to use their overvalued stocks smartly. They are well aware that the overvaluation is temporary and that sooner or later, someone will realize that the shares are overvalued, and the prices will correct. Hence, they try to make use of the higher stock price before it is called out. This is done by undertaking mergers and acquisitions and paying for them in stock.

    For instance, if company A has an overvalued share, it will try to exchange its overvalued shares for the real assets of company B. By doing so, it would have pre-empted the market. By the time the market realizes that the shares are overvalued, the company would have already acquired real valuable assets as a result of the overvaluation. Sometimes these strategies do succeed.

    However, over time, the market has realized that if a company is hurriedly undertaking an acquisition and is using its stock to pay for it, the company is probably overvalued. Hence, the announcement of such a deal leads to a correction in the value of the acquirer’s shares. Also, even if the deal goes through, these acquisitions often fail. This is because these acquisitions are carried out in a hurried manner. Hence, they often lack due diligence, and something or the other goes wrong in this complex process of acquisition.

  5. Promoter Sales: Last but not least, higher valuation leads promoters to abandon the company.

    In many cases, it has been seen that when the valuation is particularly high, promoters sell their shares. This is done to encash the shares at a higher valuation and then later use the proceeds to buy even more shares when the valuation actually settles down. However, there is a time lag between selling the shares and then actually buying them back. There is a chance that the promoter may misappropriate the funds in this time lag.

    Also, since direct selling of promoters’ shares is reported, some promoters pledge their shares to liquidate them when the valuation gets high. In many parts of the world, these pledging transactions also have to be reported.

The bottom line is that the task of the investment banker is to ensure that the shares of the company trade at a fair valuation once they are listed. The drawbacks of being undervalued are obvious. However, there are several drawbacks to the shares being overvalued as well.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Conflict of Interest in Investment Banking

MSG Team

The Components of an Investment Bank

MSG Team

Chinese Walls in Investment Banking

MSG Team