Stock Valuation

Estimating a stock's potential price

To make an asset valuation, for example a stock valuation, is to estimate
the asset's potential price, or better, its range of potential prices.

There are several methods, from fundamental analysis and valuation
to market-based valuation.

But whatever we try, the notion of value is ambiguous.
This is the "value puzzle".


Is that stock  price price
 - Just equil OK?
 - Or a bargain?
 - Or highway robbery?

Tentative definition

Although an everyday word, value is an ambiguous one.
It has several meanings.
A boon for poets, humorists and ...ideologues!

No surprise then that an "asset valuation" - for example a stock
valuation -
also refers to various notions and purposes.

To choose a practical definition, let us say that:
To make an asset valuation, for example a stock valuation,
is to estimate the asset's potential price (*),

(*) or more practically and realistically, its range of potential
      prices.

Is there a good way to evaluate an asset?

Seen from within, or from the outside?

However sophisticated are the valuation methods that specialists use,
however cool is your or my pet one(s), to determine an asset's "value"
(see below)
is still a guessing game.
 
This is normal, life itself is a travel into the unknown
and therefore made of bets.
Whatever the fog, when we have to make a decision decision about an
asset, we need to do - or get from a trusted evaluator - at least an
educated guess of its value.

In that quest there are, basically, two main methods:
  • To start with the asset presentation fundamental realities and prospects
in terms of revenues and risks. This leads to an
"intrinsic / fundamental / economic / fair" value.
  • Or to use marketmarket criteria
  Here we look for a "market based / relative" value
  Market criteria are important to estimate values, as will be seen
  in this article.

 
But here confusions should be avoided., as t
his article is
  • not about "technical analysis"
a method that shun valuations, but is supposed to detect
the seeds
of future price moves
from a hotchpotch of
chart signals and/or numerical indicators.
  • neither about a modern cousin,"quantitative analysis",
It uses (and sometimes misuses and abuses) probability
models.
        

Price or value?

Should not the price be trusted?

Normally, the generally accepted value of an asset is its market price.
So why bother to do a valuation?

=> There are three possible motives:

1) Either there is no market price (unlisted assets, illiquid markets...)

Then an estimate would be useful for bookkeeping, or for making a bid.

2) Or what the estimator looks for is a "personal value".

This is what the person consider his/her "utility", as economists say.

This is the value of the asset reckoned on the basis of the person's
own preferences, satisfactions and objectives.

They drive the person (depending on its financial means of course) to
decide to buy it or sell it.

3) Or what is looked for is the potential price of an asset

There might be several approaches.

The one that most theoreticians use is called
its "fair price" or "intrinsic price"
It is based on loupe known fundamentals and the most
objective projections


In other words the asset's economic data and prospects.

The intrinsic price is considered to differ from the current - 
- "invisible hand" given - market price.

=>
The trick is thus to detect such a "mispricing",
under the
      idea
that the market might revert later to what is estimated
      as the "fair price".

Intrinsic (or fair) value
for a business, a project, an asset

Back from the future

1) Predicting cash flows

The intrinsic value (or fair value) is estimated by taking into account
the
expected future cash flows (revenues and also final resale /
refund value) that the asset or investment  project would bring year
after year
.
It is advisable to make several scenarios (including, don't be
shy, extreme ones).

Then each one is multiplied by a probability.
Let us say a coefficient within a 1% - 99% range

The scenarios are built by taking into account the known financial
data
and are completed by a SWOT analysis and a range of
economic / financial anticipations scenarios (some with extreme
and maverick hypotheses)

The expected cash flows used in the calculation mentioned below
can be the weighed averages of all those scenarios.
=> But better make different valuations based on each
       scenario
, leaving the investor decide in full knowledge.

2) Discounting cash flows

The last step is to discount those aggregate cash flows by using
a rate of return
(*).


That rate has to include the "riskless rate" to which is added a
"risk premium" that measures the average risk
aversion
of all the market players.


The technique to value an asset on the basis projected revenues is also
known as calcul "mathematical expectancy".


(*) if the rate is
6%, an income of 10 euros received 3 years later
      has for
" PV / present value"
10 / 1,06 x 1,06 x 1,06 = 8,40 euros.
* By adding all the present values PV1, PV2 ...PVx
   calculated on every future year,
* and by applying to them a probability coefficient
,
we get the mathematical expectancy, as an estimate of what
the asset is worth today.

Can the valuation be reconciled 
with the market price?

Putting the market into the calculation.

As the market is the final judge of prices, to compare the valuation with
the actual price helps to fine tune the valuation method, adding
market pepper to it.
This fine tuning would smooth the distortions between the estimation
method and the
buysell market practices.

This is "market-based valuation" or "relative valuation".

It is done by adding market criteria to economic fundamentals
to find the asset's "extrinsic value". See details below when the asset
is a stock

Specificity about stock valuation

Stocks are specific assets that represent other specific assets, which are,
as you know, corporations.

Thus, to make a stock valuation is
* not just to apply business valuation techniques.
* but also to take into account the specificities of stock markets.

As corporations are key players in modern economies, a lot of research
has been done on how to evaluate their stocks.

* Market ratios

One of the market-based valuation methods, when the asset is a stock
is to compare its "market ratios" with those of other stocks in the
same industry or showing similar traits.

The most popular yardsticks / multiples in this case are the P/E ratios
(Price / Earnings ratios)
.
This is relevant, of course, only if the current price levels,
and the multiples of those stocks are considered
persistent or recurrent
, not the result of exceptional
temporary biases.
Remember the dotcom craze and its "exuberant" market-based
valuation criteria.
Market criteria should take into account long statistical series.

* Fundamental and behavioral valuation

An evolution of market-based valuation, combining fundamental and
market behavior is behavioral valuation.

A specific method of fundamental and behavioral financial analysis /
valuation is shown in a related article

One parameter it uses - explained with more details in the related
article - is 
the "Stock image".

It is a "behavioral" coefficient
that bridges:
* The fundamental value
     (in other words the intrinsic value seen above)
* And the market price.

As a synthesis: the value puzzle

Whatever the aim of valuation, it uses partly rational, partly
subjective methods, parameters and previsions
(see yin-
yang asset valuation)


However hard to define what is value,
assets would not be assets if they had no value.


=> Here is one of the big head-scratching puzzles in economics:
      what is value?


If we focus on asset value, it is an asset's trait that is also quite
complexconfusing to define
. Here are some approaches:

1)
It is the asset's potential to bring satisfactions, among them
     incomes
.


2)
It is often confused with its (current) price.

3)
One way to define it is that it is an estimate of the potential price...
...by some reliable experts, you and me for example ;-).
Here a combination of fundamental analysis, market criteria and
tools given by behavioral finance  (such as the "stock image" shown
above) can help.
4) In another approach, there is a personal value

(in other words the player's utility or preferences).
=> It is the price an individual is ready to pay (if he buys), or will
      accept to be paid (if he sells).

Those individual values are the sources of the bids / asks by market
participants.
Their balance determines the equilibrium price reached on the
market.
5) As markets might do that pricing job imperfectly, people tend to
       assume
- rightly or not -  that goods and assets have a value per se.

That mystique is not fully convincing.  as it sees the world of assets
separated from the world of people who
produce, use, exchange and
own them

But if it delivers a few clues, why not!
 
This - rather theoretical - value might be calculated by using the
current economic fundamentals and prospects, and combining them
by using the prevailing valuation paradigm / formula.

What is called value in that respect is a theoretical "fair (right)
price"
(as seen above in the intrinsic or fair value chapter),
or, when talking about stocks, the "intrinsic economic value".

Reference and further readings

From Peter Greenfinch's Behavioral finance glossary

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M.a.j. / updated
: 09 Sept. 2015

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