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Why I think the Darktrace share price could keep falling after the 15% drop last week

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Darktrace (LSE:DARK) has been one of the best performing IPOs that I’ve seen this year. After floating at 250p in April, the Darktrace share price almost touched 1,000p in late September. However, it has moved lower since then, falling another 15% last week to close just above 800p. Is this simply a natural correction after such as large spike, or is this the beginning of a larger fall?

A negative report

The main reason for the underperformance last week was the issue of a negative report from broker Peel Hunt. The company has recently started to cover the stock for equity research, with the latest update being a sell notice. In fact, the forecast price that the company has put out is 473p. This is over a 30% move lower from the current Darktrace share price.

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The main reason that was cited in the report was that “while we believe strong growth rates will continue, we also see a disconnect between the valuation and the ultimate revenue opportunity“. It also noted that “having considered the potential market size, the intensifying competition, and Darktrace’s limited R&D spend, we take a more grounded approach to our valuation, giving a target price of 473p”.

I’ve written about the company several times over the past few months. Each time, I’ve said how I’m not going to buy given the fact that I think the business is overvalued and is in a market with high competition.

The report from Peel Hunt saw investors take this more seriously, hence the sharp slump in the share price when the report came out. 

The Darktrace share price could fall further

I think that this fall is the start of a larger drop. And I feel that it’s only a matter of time before more analysts come out in agreement with Peel Hunt regarding the valuation and other points mentioned above.

I don’t think that the shares are in danger of falling back to the IPO level. But I feel they’re likely to come down to reflect the actual growth rate of the company. For example, in the latest results for the quarter ending 30 September, good growth was seen. It grew the customer base by 42.7% year-on-year. Revenue grew by 50.8%. These growth rates were in line with the expectations of Darktrace.

So it looks like a growth rate for the year of between 40% and 50%. Yet the share price has shot up over 220% since April. Even if I make allowances for an optimistic outlook, the premium on the shares at the moment is still too high. Therefore, I agree with the thinking that around 500p would reflect a fairer valuation.

I could be wrong here, and the share price could continue to rally from this dip. After all, despite my concerns for months, the share price has headed higher, not lower. I could simply be not appreciating the uniqueness or value that Darktrace has, or the potential large revenue streams for the future. 

Yet until I’m convinced of this potential, I won’t be investing in Darktrace.

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jonathansmith1 and The Motley Fool UK have no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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