The Pitfalls of Overvaluation

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.