All that glitters

 

The electrical appliance retailler AO has just completed its first year as a listed company. At the time of its stock market debut the company was worth £1.2 billion.

 

A year later underlying earnings of £16.5 million compared to predictions of £18.6 to £21 million saw the share price fall to 192 pence half the value of the float euphoria.

 

It is obvious that any company about to float must by definition be bullish about its prospects. There is a growing trend of companies coming to the market whose history suggests that there is no basis for concluding that they will ever make money.

 

That’s the stock in trade for a company about to float whilst losing money. If it were making a profit before its IPO, it would be harder to make bullish forecasts about how much profit the company will generate in the future.

 

Ironically for a company losing money, the sky’s the limit when it comes to predicting how bright its future revenues will be.

 

In tandem with the ability to forecast a spectacularly profitable future is the functioning of one of the market’s most basic laws: momentum. In other words powered by its own performance a stock that is gaining value up will continue to appreciate in value just because it is going up.

 

More specifically, when there is no real positive cash flows on which to value a stock, its price will rise because investors who do not own the shares will want to climb aboard the bandwagon rather than miss out.

 

This wave of “new buying” can help to drive up the shares further, which will attract a new investment creating a dangerous bubble.

 

It would probably be a more prudent strategy to avoid the money-losing IPOs and invest in companies who are making a profit before they try and float their shares. 

 

However forecasting the price of stocks remains an inexact science and unfortunately for the investor there is as yet no failsafe basis on which to explain why stocks go up and down.