Zomato’s flop show raised many important questions

The hype surrounding the stock was mind-blowing. One fund manager compared this to an Infosys moment, where he talked about the stock’s potential to generate unprecedented wealth for its shareholders, as it did in subsequent years. However it is worth mentioning here that unlike Zomato, Infosys’ IPO was not fully subscribed, and had to be picked up by the underwriters.

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

So what? On a simple level, the world was excited about investing in stocks in 2021. Not so in 2022. At least not that much. Due to this, foreign investors have pulled out of the Indian stock market. While domestic investors are buying, they are clearly not buying enough to ensure that stock prices don’t fall. Of course, different stocks have fallen at different rates and Zomato has fallen more than others. A stock’s price should ultimately be the discounted value of its expected future earnings. In good times, future earnings are considered higher and the discount rate is lower. When times change, projected future earnings fall and the discount rate rises. This is at the heart of the valuation model adopted by analysts in this business.

When times are good, investors don’t ask the most basic question of where future earnings are going to come from. But when times change, they turn around to ask. Something similar happened with loss-making company Zomato, which is still trying to figure out its business model. In its current business model, when its revenues increase, so do its losses. Actually, Zomato is not the only company that got listed in the stock market last year. There are many other such companies, which include One97 Communications (Paytm), PB Fintech etc.

The steep fall in the prices of such shares raises several points. Firstly, when IPOs of such stocks came, investment banks and stock brokerages came together to discuss about these companies. While this is a part and parcel of the IPO game, the trouble with this case was that the companies didn’t make any money.

Second, the promoters were allowed to sell a part of their stake to retail investors. Here by retail investors, we mean those who bought the stock directly and those who bought it through mutual funds and insurance companies. Should it really be allowed? Should the caveat emptor be allowed to work in this case? This was actually not entirely true of Zomato, where the company raised funds for future expansion, but in other cases, the offer for sale was a major 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 projected to last until 2041 to justify the IPO price. The problem is that anything on an Excel sheet can be justified, but does it have to result in uninformed retail investors who are largely visiting with their friends and family?

Fourth, it raises very broad questions. At the heart of the current financial system are large-scale financial services groups that market investment banks, stock brokerages that help investors buy shares in IPOs, mutual funds and insurance companies that help investors buy shares in IPOs. It helps, though indirectly, and ultimately, banks and non-banking finance companies, who are willing to borrow and lend money to investors willing to invest in IPOs. The point is that the system is so structured that it makes sense for insiders to lower the IPO price. Of course, outsiders (read retail investors), who come late to the stock market party, pay the price in the end.

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