Zomato’s flop show raises many important questions

The hype around the stock was mind boggling. One fund manager equated it to being an Infosys moment, where he talked about the potential of the stock generating unprecedented wealth for its shareholders like the latter did over the years. Though it is worth mentioning here that unlike Zomato, the Infosys IPO was not fully subscribed to, and had to be picked up by the underwriters.

The trouble is that a little over a year later things are looking very different. At the time of writing this on 27 July, the Zomato stock was trading at ₹43, down as much as 75% from its all-time high of ₹169 apiece seen on 16 November.

So, what happened? At a simple level the world at large was excited about investing in stocks in 2021. In 2022, it isn’t. At least, not that much. This has led to foreign investors selling out of Indian equities. While domestic investors have been buying, they clearly haven’t been buying enough to ensure that the stock prices don’t fall. Of course, different stocks have fallen at different rates and Zomato has fallen more than the others have. A stock’s price should ultimately be the discounted value of its expected future earnings. In good times, the future earnings are assumed to be high and the rate of discount is low. When times change, the assumed future earnings fall and the rate of discount rises. This is at the heart of the valuation model followed by analysts in this business.

When times are good investors do not ask the most basic question of where the future earnings are going to come from. But when times change, they do get around to asking this. Something similar has happened to Zomato, which is a loss-making company, still trying to figure out its business model. In its current business model, when its revenue goes up, so do its losses. In fact, Zomato is not the only such company which listed on the stock market last year. There are several other such companies, including One 97 Communications (Paytm), PB Fintech, etc.

The massive fall in prices of such stocks raises multiple points. First, when the IPOs of such stocks came around, the investment banks and the stock brokerages came together to drive up the buzz around these companies. While this is a part and parcel of the IPO game, the trouble was in this case the companies did not make any money.

Second, promoters were allowed to offload a part of their stake to retail investors. By retail investors here we mean those who directly bought the stock and those who bought it through mutual funds and insurance companies. Should this really be allowed? Should caveat emptor be allowed to operate in this case? This wasn’t really totally true about Zomato, where the company did raise money for future expansion, but in other cases, the offer for sale was a larger part of the money raised through the IPO.

Third, analysts working at stock brokerages worked over time to justify the price of such stocks. In one case, earnings were forecast up until 2041 to justify the IPO price. The trouble is anything can be justified on an excel sheet, but should that lead to uninformed retail investors who are largely going by what their friends and family are doing, have to face the consequences of that?

Fourth, it raises a much broader question. At the heart of the current financial system are largely financial services groups which run investment banks taking companies to the market, stock brokerages which help investors buy shares in an IPO, mutual funds and insurance companies which help investors buy shares in an IPO, albeit indirectly, and finally, banks and non-banking finance companies, which are ready to lend money to investors looking to borrow and invest in IPOs. The point is that the system is so structured that it makes sense for the insiders to drum up the price of an IPO. Of course, the outsiders (read the retail investors), who come to the stock market party late, end up paying the price for it.