Here’s Why Small Company Stocks Are Trading at Inflated Prices

Bhatia noted that recent events have highlighted the lack of sufficient checks and balances: “It appears that the due diligence expected of auditors, stock exchanges and investment bankers may not be sufficient.

This comes after SEBI issued a recommendation on investing in listed companies in the SME segment.

It appears that some SME companies and their promoters are posting post-listing advertisements that create a favourable impression about their companies and generate positive sentiment among retail investors. This allows the promoters to sell their shares at inflated prices.

While issuing a warning is a step in the right direction, expecting stock market operators to conduct due diligence in a way that helps potential investors shows a poor understanding of history.

Those involved in selling stock are incentivized to maximize the sale price by creating a narrative that supports it, regardless of whether the company’s business model or earnings justify it.

History illustrates this. In 1720, there was the Mississippi Bubble in France, and the South Sea Bubble in Britain the same year. Britain also experienced a railroad craze in the 1830s and 1840s.

In the Roaring 20s, the US stock market boomed until it crashed, leading to the Great Depression. Then there was the dot-com bubble of the 1990s. Closer to home, a spate of IPOs launched in 1994 saw their promoters disappear along with the funds raised.

Almost all of these speculative bubbles and manias involved suspicious activities and selling of stocks at very high valuations.

Consider the South Sea Bubble. Walter Bagehot in Lombard Street: Money Market Description details the questionable purposes for which the companies sought funds: “To make salt water fresh… To build hospitals for illegitimate children… To trade in human hair… To the wheel of perpetual motion.” But the most audacious was: “For an enterprise which in due time will be disclosed.”

We no longer live in the 18th century, and such blatant fraud is not usually possible today. However, in the 1990s, investment bankers inflated the value of many Internet companies that had virtually no business prospects, projecting a successful future in order to sell these stocks to retail investors at inflated valuations.

If investment bankers had had a habit of rejecting such deals, the dot-com bubble largely might never have happened.

Of course, no investment banker has ever been sent to prison for selling stock at too high a price. If they had, the concept of publicly traded stocks and limited investor liability might not have taken off, and capitalism as we know it would never have come into being.

A similar scenario played out in India in the 2020s. Shares of several venture capital-backed companies with minimal business models were sold to investors at extremely high valuations.

Part of this “dressing up” involves presenting better results in the run-up to the IPO. Auditors and investment bankers play a key role in creating results that make these companies look much stronger than they actually are.

Of course, that’s only part of the story, since the supply of shares sold through an IPO also depends on demand. In reality, investors typically buy shares only after the market has risen significantly.

This trend seems to be also present in the SME IPO space. Over the past decade, more than ₹14,000 crore was raised through IPOs of companies on the SME platform. Out of this ₹Rs 6,000 crore was raised in 2023-24, with some IPOs in 2024-25 seeing subscriptions exceeding the permissible limit by several hundred times.

As Bagehot wrote, “The fact is that the owners of savings… pounce on anything that seems to promise something, and when they discover that these apparent investments can be sold at a large profit, they pounce on them even more.” So the sellers of stocks are simply taking advantage of this behavior.

This risk is inherent to the limited liability system that exists. This does not mean that stock marketers only deal with companies that have questionable business models. If they did, the stock market would never have created so much wealth.

Indeed, an alternative to the current system would be to return to the old way of controlling capital issuance, where a bureaucrat in the finance ministry would decide how many shares a company could issue and at what price. This was abolished in 1992 and returning to it is clearly not an option.

Where does that leave us? In an ideal world, those selling stocks would do a thorough due diligence, recognizing that once a bubble bursts and investors lose money, they are unlikely to get back into the business soon, which would affect their profits. But that is a concern for the future, and who knows when that tomorrow will be. Until then, there is easy money to be made.

Indeed, sometimes what seems to be a flaw in the system is in fact its feature and principle. buyer must be careful is often understood only in retrospect.