Too often, IPO valuations are overhyped, overvalued, and (ultimately) overpriced.
The result? Investors lose confidence, stocks plummet, and companies struggle to maintain stability in the market.
For example, in the US, a study has found that 21.61% of IPOs exhibit negative first-day returns.
So why does this happen? What causes companies to fall into the overpricing trap, and how can they avoid it?
Main reasons why IPO valuations go wrong
#1 Excitement outweighs reality
Companies want the highest possible IPO price. That makes sense. A higher valuation means more capital raised, better financial optics, and a strong initial buzz.
But this focus on maximizing the IPO price can sometimes override a more fundamental question: is the valuation actually realistic?
These companies usually have unrealistic growth expectations. They present aggressive projections that may not align with actual market conditions.
There’s also the media frenzy. In these cases positive press coverage amplifies demand, sometimes based on speculation rather than fundamentals.
FOMO is another reason where investors, seeing the hype, rush in without fully analyzing the stock’s real value.
But…When companies rely too much on hype, they set unrealistic expectations. If post-IPO earnings fail to meet those (very high) expectations, investors pull out, and the stock tumbles. We’ve seen this happen with high-profile companies that launched at inflated prices, only to crash within months.
#2 The role of investment banks in setting the wrong price
Investment banks do have a great role in IPO pricing, but they don’t always get it right. Their job is to help companies maximize their IPO price while ensuring that investors are willing to buy.
But sometimes… their incentives create a pricing mismatch. Take the case of Citigroup which allegedly provided “misleading” and “inaccurate” advice when working for a UK-based investment firm on a prospective public listing.
Why this happens:
- Banks want to price the stock high enough to generate big fees, but not so high that it flops. This balancing act doesn’t always work.
- Banks conduct roadshows and gather investor feedback, but they don’t always get a full picture of actual demand. If they overestimate enthusiasm, the IPO price can be set too high.
- Some banks push for higher valuations to make the IPO appear more successful. A billion-dollar IPO looks better than a $ 500-million one (even if the lower price is more realistic.)
Companies should work with banks, but also conduct their own market analysis. Relying too much on underwriters without questioning their assumptions can lead to inflated pricing.
Don’t rely solely on investment banks or venture capitalists to set the price. Gather feedback from a variety of investors, analysts, and financial experts who understand the nuances of your business and its market potential.
#3 Comparing to the wrong companies
Many IPO-bound businesses set their IPO valuations by looking at high-performing public companies, EVEN if their own fundamentals don’t match.
The logic goes, “If they can do it, why can’t we?”
Unfortunately for these companies, valuation isn’t just about picking a number that sounds impressive. It’s about aligning your company’s worth with its actual performance as well as growth potential, market position, and risk factors.
Sometimes it’s a “small fish, big pond” – type of situation.
For example, Facebook (now Meta) went public in 2012 with a valuation of over $100 billion.
But (huge BUT) by the time they listed, they had:
- already built a massive user base,
- had a proven business model,
- and were consistently growing.
Facebook’s IPO was supported by years of strong revenue generation and profitability.
For a small startup that’s still figuring out its business model or hasn’t demonstrated the same revenue potential, trying to aim for that same valuation is like trying to run a marathon before even mastering a brisk walk.
The result? Overpricing.
The market won’t buy into inflated IPO valuations when a company hasn’t proven its worth!
And this can lead to a massive stock drop post-IPO, as investors realize the company doesn’t yet hold the same weight or future growth prospects as the ones it’s comparing itself to.
So: focus on comparable companies at your stage. Rather than comparing yourself to the Apples and Googles of the world, look for companies that were in a similar stage when they went public.
These comparisons will provide a more accurate benchmark for setting expectations and valuations.
How to fix the IPO valuations process?
So how can companies avoid the overpricing trap? It starts with a smarter, more balanced valuation process.
Steps to get it right:
- Look at fundamentals, not just hype.
- Growth projections should be realistic, not just what investors want to hear.
- Assess market conditions properly because your company’s value isn’t just about the business but also about when it goes public.
- Listen to different types of investors.
- Remember that long-term investors provide better pricing signals than short-term speculators.
- Be willing to price lower if needed.
- Ensure that the timing of your IPO aligns with favorable market conditions.
Final thoughts
The goal of an IPO isn’t just to raise money. It’s to create a stock that investors trust. A high IPO valuation means nothing if the stock crashes after listing.
So, instead of chasing the highest possible valuation, aim for one that aligns with realistic market demand.
Also a well-priced IPO leaves some room for post-listing growth. When investors see value, they’re more likely to hold onto shares, creating a stable market for the stock.
Companies that aim for a price that is grounded in reality, and that reflects their true worth, stand a much better chance of maintaining investor trust.
The goal should not be to make a splash on day one but to build that solid foundation for future growth and investor confidence.is aute irure dolor in repreh enderit in voluptate velit esse cillum dolore eu fugiat nulla pariatur.