Colin McLean: How can investors tell if new firms on stock market are valued too highly?

Private investors rarely give much thought to whether share prices are “right” – capturing prospects and risks fairly. After all, the investment industry is full of smart professionals paid to think about value. It is only in stock market turmoil that the question gets serious attention.

Fortunately, there are clues to whether a company’s share price is likely to be roughly right or carrying much more risk.

Shakeouts happened at the end of the dotcom boom in 2000, and again a few years later as the financial crisis unwound.

What are the factors today that are producing so much volatility? How could an e-commerce business valued at billions of pounds – as THG was last year – lose more than 80 per cent of

its value?

A recent pattern of heavy falls in newly listed companies has been seen across the technology and e-commerce sectors – in the UK, America and Europe. It seems private valuations of some businesses cannot be carried successfully into the listed stock market.

Investors need to recognise the strong incentives that encourage over-valuation of big stock market flotations, even when lots of clever professionals are involved in assessing worth.

Private equity backers aim for a profit and usually there is a large cut for management rewards and for the issuing investment bank.

The only group with little incentive to hype are the stockbroking analysts who are not involved in the promotion. They may see a new issue

as far too highly priced but there is little they can do about that.

Indeed, even after flotation it can be hard to bring an alternative view into the reckoning. Hedge funds that used to highlight pricey and risky businesses have given up, losing heavily when shares like Tesla and GameStop carried on rising regardless. This has now removed an important stock market balancing mechanism.

UK regulation also makes it difficult for anyone other than a company’s own paid stockbroker to make research freely available to the investing public. And while some private equity backers and company founders may also believe shares are overvalued, they are often restricted from selling. Only a minority of shares might be

freely trading, meaning the views of the most knowledgeable investors in a company might not be what is setting the share price.

The value problem may be more acute with new issues, but it is also felt more broadly

across the stock market. Low interest rates have encouraged share buybacks and many executives have incentives to achieve high share prices.

Each of these changes – incentives, buybacks, private equity growth and regulation – may seem minor, but collectively create a big valuation problem.

Investors need to focus on whether a business attracts independent comment and even contrary views. It may take several years after listing before research coverage and ownership really broadens out.

That may mean missing out on what looks like the fastest period of growth, but it should mean lower risk of over-valuation. Fortunately, businesses that truly have a competitive edge typically can maintain superior growth rates for some time. Opportunity should still be there.

Further dangers may lie ahead. In the aftermath of the dotcom boom, many founders and early backers continued selling even after big share price falls. Being in at the ground floor, their

cost price for shares was much below the stock market price, and their ultimate focus was simply selling for a profit.

It is worth remembering that a share price that looks like a big loss on the stock market may still be making money for some lucky investors. A share price can mean different things to each investor.

Colin McLean is managing director of

SVM Asset Management.