Oberon Houston, Oil & Gas Investment Banking

Aswath Damodaran is one of the most respected voices in equity valuation. A professor at NYU Stern Business School, he is often referred to as the "Dean of Valuation" and is widely followed by equity analysts, investors and corporate finance professionals. I once overheard a conversation between equity research analysts about which valuation techniques were most useful. One simply replied: "Damodaran. That's all you need." For anyone interested, his Stern corporate finance courses, tutorials and valuation materials are freely available online.

In his latest blog post, Damodaran discusses stock market indices, prompted by the recent IPO of SpaceX and a debate around whether companies such as SpaceX, Anthropic and OpenAI should be included in major indices such as the S&P 500. Critics argue that admitting companies of such scale and valuation could distort index composition and expose passive investors to risks they may not fully appreciate. Damodaran uses that debate to explore a broader set of questions: how indices are constructed, how companies are added or removed, whether very large additions fundamentally change an index, and whether index inclusion itself creates value for shareholders.

His argument is that investors, including in this case some of his own students, can confuse cause and effect by assuming index inclusion, whether in the S&P 500, FTSE 250 or elsewhere, creates value. Damodaran argues that this gets causality backwards.

The confusion stems from what happens when a company enters an index. Passive funds tracking that index become buyers of the stock. However, active investors know those flows are coming. If the resulting demand pushes the share price above fundamental value, active investors have an incentive to sell, short or reallocate capital elsewhere. Over time, those forces should arbitrage away any premium created solely by index inclusion. In Damodaran's framework, indices do not create value. They measure value.

I agree with that, especially for large and highly liquid US-listed stocks. However, the argument becomes more nuanced when applied to smaller UK-listed companies, where index inclusion is often bound up with questions of market structure, liquidity and investor access. Serica Energy is a useful example, not least because it is a stock I follow closely and have written about extensively, particularly given the ongoing debate around a possible move from AIM to the Main Market and eventual FTSE 250 inclusion.

A potential move being framed as a passive flow story: more buyers, higher share price is not correct. But I suspect the more important issue is liquidity. Unlike a large US company, Serica trades on AIM and remains relatively illiquid. Many institutional investors cannot own AIM stocks. Others can, but position sizes are constrained by liquidity considerations. As a result, the pool of potential capital is narrower than it would be for an equivalent Main Market company.

Improved liquidity does not change reserves, production or cash flow. However, it can reduce the return investors require to own the shares and expand the universe of potential shareholders. That can support a higher valuation multiple without changing the underlying business.

So while I agree with Damodaran that FTSE 250 inclusion does not create intrinsic value, I am less convinced that the impact for a company like Serica would be negligible. The benefit is unlikely to come from passive flows alone. It is more likely to come from improved liquidity, broader ownership and a reduction in the discount associated with being an illiquid AIM-listed stock.

Main Market is not a mechanism for creating value. It is a test of the extent to which AIM itself is preventing that value from being properly recognised. Readers of my recent posts will know I am not a fan of AIM, and this is one of the principal reasons.

If Serica were to migrate to the Main Market, improve liquidity and eventually enter the FTSE 250, the key observation would not be the passive buying itself. The more interesting question would be whether a broader universe of investors reaches a different conclusion on the value of the company's underlying assets and cash flows.

If the valuation gap narrows, it would suggest that AIM status and liquidity have been meaningful impediments. If it does not, the market is effectively telling investors that the discount lies elsewhere.

It should be recognised that a move to the Main Market would be about much more than index inclusion and passive flows. Serica's growth ambitions are central to the broader strategy. However, in this specific context, FTSE 250 inclusion is less interesting as a catalyst than as an experiment. It may provide a useful indication of how much of Serica's discount is driven by fundamentals, and how much is driven by the limitations of its current market structure on AIM.

KeyFacts Energy: Serica Energy UK country profile    l   KeyFacts Energy: Commentary
Original article