Here’s why the shares of small businesses sell at inflated prices

Bhatia noted that recent events have highlighted a lack of sufficient checks and balances: It appears that the due diligence expected from chartered accountants, exchanges and merchant bankers may be inadequate.

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This follows Sebi’s advisory on investing in companies listed in the SME segment of stock exchanges.

It seems that some SME companies and their promoters have been making post-listing announcements that create a favourable impression of their companies and generate positive sentiment among retail investors. This allows promoters to offload their shares at inflated prices.

While issuing an advisory is a step in the right direction, expecting those in the business of selling shares to carry out due diligence in a way that will help prospective investors only reveals a weak understanding of history.

Individuals involved in selling shares are incentivized to maximize the sale price by crafting a narrative to support it, regardless of whether the company’s business model or earnings justify it.

History illustrates this. There was the Mississippi Bubble in France in 1720, followed by the South Sea Bubble in the UK the same year. The UK also saw a railway mania in the 1830s and 1840s.

In the roaring 1920s in the US, its stock market boomed until it crashed, leading to the Great Depression. Then there was the dotcom bubble of the 1990s. Closer home, numerous IPOs launched in 1994 saw their promoters vanish with the funds that were raised.

Almost all these bubbles and manias involved questionable activities and the sale of shares at extremely high valuations.

Consider the South Sea Bubble. Walter Bagehot in Lombard Street: A Description of the Money Market details the dubious purposes for which businesses sought to raise funds: “To make Salt Water Fresh… For building of Hospitals for Bastard Children… For trading in Human Hair… For a Wheel of Perpetual Motion." But the most audacious was: “For an Undertaking which shall in due time be revealed."

We no longer live in the 18th century and such blatant fraud is not usually possible today. However, in the 1990s, merchant bankers did inflate the value of many dotcom companies with barely any business prospects, projecting a prosperous future to sell retail investors these shares at excessive valuations.

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If merchant bankers had made a habit of refusing such deals, much of the dotcom bubble might never have occurred.

Of course, no merchant banker ever went to jail for selling shares priced too high. If they had, the concept of company shares being listed and investors bearing limited liability may not have taken off and capitalism as we know it would never have existed.

A similar scenario has unfolded in India in the 2020s. Shares of several venture capital-funded firms with minimal business models have been sold to investors at extremely high valuations.

Part of this ‘dressing up’ involves presenting improved figures in the lead-up to an IPO. Chartered accountants and merchant bankers play a crucial role in producing numbers that make these companies appear much stronger than they actually are.

Of course, this is only part of the story, as the supply of shares being sold through IPOs also depends on their demand. In fact, investors typically buy stocks only after a substantial market rise.

This trend appears to be occurring in the SME IPO space as well. Over the last decade, more than ₹14,000 crore has been raised through IPOs of companies on the SME platform. Of this, ₹6,000 crore was raised in 2023-24, with some IPOs in 2024-25 being oversubscribed hundreds of times.

As Bagehot wrote: “The fact is that the owners of savings… rush into anything that promises speciously, and when they find that these specious investments can be disposed of at a high profit, they rush into them more and more." So, the sellers of shares merely take advantage of this behaviour.

This risk is inherent in the system of limited liability as it exists. This is not to suggest that those in the business of selling shares only deal with companies that have dubious business models. If that were the case, the stock market would never have created so much wealth.

Indeed, the alternative to the current system would be to revert to the old way of controlling capital issues, where a finance ministry bureaucrat would determine 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.

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So, where does this leave us? In an ideal world, those selling shares would perform thorough due diligence, given that when a bubble bursts and investors lose money, they are unlikely to return to investing soon, which would affect their earnings. However, that is a concern for the future, and who knows when that tomorrow will come. Until then, there is easy money to be made.

Indeed, sometimes what appears to be a flaw in the system is actually a feature and the principle of caveat emptor is often understood only in hindsight.