When a company goes public and sells shares to a wide range of investors, price discovery happens. The price of the shares is based on what investors think those shares are worth.
In any competitive economy capital invariably seeks the areas of highest expected return. – Pat Dorsey
Usually, a company is started by its founders. As the company grows its profitability, the set of founders and early investors may require liquidity and they exit a portion of their holdings. This process also enables the discovery of a ‘fair price’ for the company.
So in a way, there is a difference between prices quoted in private markets versus public markets. We often say that a private company is available at a discount to its closest publicly listed company, this discount is a liquidity discount.
When a company goes public and sells shares to a wide range of investors, price discovery happens. The price of the shares is based on what investors think those shares are worth.
Each investor decides what he or she thinks the value of the shares should be and decides based on whether the current price is above or below that estimate of the fair value.
Interestingly, private company valuation depends upon the performance of the company. It is based on the future cash flows of the company.
However, market liquidity can create an illusion of value. In 2020/21, interest rates were all-time low, the risk capital flow reached its peak and a lot of start-ups received funding. These start-ups and founders were celebrated across the media.
In the next 18 months, liquidity dried up and these start-ups reached an existential crisis. The movement of interest rates created liquidity, inflation peaked, interest rates increased, and liquidity reduced. It’s a textbook version of market play.
This means, essentially, the private investors in 2020/21 were not paying for the performance of the investee company rather they were caught up in FOMO.
Public markets are the worst. Any reasonable businessperson who is running a cash-rich business and is under no pressure from an outside capital contributor will choose to stay private. This way he/she can focus on the business.
However, public markets are filled with emotions. Even if the company does well but does not meet investor’s expectations, the investors would be disappointed.
What’s the point of doing fundamental analysis, then?
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” ― Benjamin Graham
An astute investor will always be looking for opportunities where the market is depressed, often a short-term phenomenon. As the market gets euphoric, a smart investor is on the sidelines.
Not only does the share price drop when the market realizes that the company won’t be able to deliver but regaining credibility may take years.
Conversely, if the market’s expectations are too low and you have a low share price relative to the opportunities the company faces, a smart investor jumps in.
In the short term, the movement of the market is driven by capital flows, however, in the long run, fundamentals must shine and share prices respond.
The collective wisdom of the market is too good.
Be a long-term equity investor.