Behavioral finance FAQ / Glossary (Valuation, value)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

(asset, stock) Valuation


See stock valuation page + value,
(fair) value, value puzzle,
utility,
behavioral valuation, PER effect

Potential estimate


Sorry for the tautology, the goal of an asset valuation
is to determine an asset "value" (see the glossary article).

But, as value is an ambiguous word, find here, not one more
precise definition, but a choice of precise definitions.

Up to you to do the sorting ;-)

Definition:

To make an asset valuation is to produce
an estimate of the asset's potential price,
or better of its range of potential prices (*).

(*) see "range estimate aversion".

However sophisticated are the valuation methods used, to determine an
asset's "value" (see below) is still partly a guessing game.

Price or value?

Should not the price be trusted?

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

There are at least three possible motivations for that homework:

1) Either there is no market price (the case for unlisted assets).

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


2) Or the value in question is what could be called the estimator's

    "personal value"   aka its "utility", see that word).

This is the value a potential buyer or seller attributes to an
asset according to
his/her own preferences, satisfactions and
objectives
, so as to decide to buy or sell.


3) Or what is looked for is an asset's potential price  

There might be several approaches.

The one used by most theoreticians is called its "fair price" or
"intrinsic price" and is based on known fundamentals (and
objective risk and income previsions.It is considered to differ
from its 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 the estimated "fair price".

Well, a good compromise is to try to blend
fundamentals  and market criteria under a market-
based valuation
(see below) or
behavioral
valuation
 
(see that phrase).

Can valuation be reconciled with market price?

Adding market spices to the calculation pot.


As the market is the final judge of prices, to compare the valuation with the
current price helps to fine tune the valuation method.

This fine tuning - with some market grease added - would smooth the
distortions between the estimation method and market practices.

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

It adds market criteria to economic fundamentals
to find the "extrinsic value" (see that phrase) of the asset.

One of the methods is to compare the stock's "market multiples" to those
of other stocks
that belong to the same industry or show similar traits.

The most popular yardsticks in this case are P/E ratios.

This is relevant, of course, only if the current price levels and
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.

An evolution of market based valuation, combining fundamentals
and market behavior, for example via a "stock image coefficient"
,
is behavioral valuation (see that phrase)

Conclusion on valuation methods

This is not just like boiling an egg,
the recipe needs various ingredients.

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

Value




Many messages every month, as
a classic of economics / finance,

+ see above "valuation" + below
"fair value, value investing, value
puzzle, value stock", preference,
utility

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, to define it also quite confusing.

Here are some approaches:

The price-related approaches

1) The value of an asset is often confused with its (current) price.

This is understandable but far from enough to decide to buy or sell.

2) One way to define it is to say (see "valuation") that it is an estimate

of the potential price by some reliable experts,

you and me for example ;-)

The satisfaction-related approaches

Happy value?

3) Another way is to see it as the asset's potential to bring
    satisfactions and among them incomes.

3b) As a related approach, there is a personal value, in other
      words  the player's utility or preferences : see "utility".

It is the price an individual is ready to pay (if he buys), or would
accept to be paid (if he sells), for an asset, a goods, a service,
a commitment or liability.

Those individual values are the sources of the bids / asks by
market players.

Their balance determines the equilibrium price reached on the
market.

3c) Sometimes also people call value the difference between

the price they pay and what they perceive they get in exchange.

Here we have value = (utility - price).

That perceived difference can be positive, equal to zero
or (sadly, as felt sometimes after the exchange) negative

The formatted approaches

 Schoolbook value?

4a) As markets might do that pricing job imperfectly, people are
      tempted - rightly or not - to suppose that goods and assets have
      a value per se
.

It might be calculated by using the current fundamentals and
prospects and combining them under the prevailing
valuation paradigm / formula
.


What is called value in that respect is a theoretical "fair
(right) price"
,or, when talking about stocks, the "intrinsic
economic value"
(see those articles).

4b) Not to mention, an idea some ideologues still cling to, the
     
reductive old definition by classical economists, from Smith
      to Marx, who saw
value as a  "quantity of work".

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

(fair) price / value / valuation



Many messages every month on
price or value
+ see price, value,
fundamental analysis, intrinsic,
fairness

Is it worth what we pay?

Looking for the true Grail of the true value.

What is called the fair price, or "right price", or (fair / intrinsic / economic)
value of an asset refers to:

In common language, a price that is supposed to be fair
   for all parties
(see fairness),


In economic language, an estimate of value by experts
    using economic criteria they consider objective

It might differ in the short term, and sometimes durably, from the
market price.

For more details, see below "(economic / intrinsic) value",
and also "fundamental analysis".


In the narrow accounting sense:

Either the market price, if there is one available,

Or if not, an estimate that takes into account market criteria.

If we apply the economic / fundamental concept to a stock that is listed in a
market,
the economic fair value might be defined as:

A theoretical / potential price that could normally be
expected on the basis of economic fundamentals and
prospects
,
by using a generally accepted valuation
technique.

The "(economic / expected / fair / intrinsic) stock Value" article details
the technical valuation aspects, for stocks notably.

Is such a "fair" valuation reliable and useful?

Can you trust it just because it looks fair?

If the calculations were right, and markets were efficient (see that term), prices
would normally be very close to the fundamental fair value.
Or at least they would revert to it quite rapidly.

Well, a lot of "ifs"!

Whatever the care with which the calculation is done, and the analyst's past
record, there is some subjectivity in such "fair" valuation.

But anyway it can have some usefulness:

Fundamental investors find it essential to have such an 

estimate and compare it with the effective market price 
before taking their decisions.

Behavioral finance researchers can also use it, while  
  
knowing its limitations, to detect mispricing 

(over- / under-pricing, see those words).

See also the "value puzzle", "intrinsic value" and "extrinsic value" articles

about those relevancy and reliability issues.

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed/ discussed,
i: incidental

(economic / expected / fundamental / intrinsic)
    stock
Value

See valuation, value, fair price,
fundamental analysis, mispricing,

Standard cooking recipes
served as fair stock valuation models.

Definition


The "intrinsic economic value" or "fundamental value" is a notion commonly used
as a basic approach (but sometimes completed by other ones, such as market
comparisons) in businesses valuation and in capital asset valuation.

It can also in some cases be used for other assets, or even goods and services.

This theoretical economic concept supposes that:

Goods, assets, services, and whatever other material or immaterial things
   which can be bought and sold,
have a value per se,

It can be calculated by using some theoretical parameters .

How this concept raises some doubts

It is rather strange to consider the value of something as
independent
of the people who use, produce, buy, sell, get,
give, hate or love, want or do not want, need or do not
need
it.


Anyway, if the models include assumptions about those human
aspect
s
and give practical methods, why not use them?

But of course those results fresh from the computer should
be taken with tons of precautions.

Some even see the fundamental value as an economic myth
that does not exist per se.
They see too many uncertainties that
hinder an objective calculation (see uncertainty, fundamental
analysis...).

They think it exists only in the mind of those who estimate it or
refer to it.

The case of company's stocks

Investing for the business future, and our wallet's future.


Luckily, when we focus on the value of a stock, we can be more precise and
define it as its "estimated potential price" (as seen above:
see "valuation" and "value").

What makes the equity value notion a bit easier to grasp is that normally, when
investing in stocks, their main purpose is to make money.

Thus we might assume that the most relevant and rational
elements to assess a stock are its expected
return 
and the related
risk .


The intrinsic / fair / economic / fundamental / potential value (whatever the
name given)
calculation would thus:

1) Be based on the current fundamentals (as a starting point) and
   
on future economic prospects.

The most important data are the current and projected earnings,
cash flows or dividends of the firm.

2) Combine those identified data with valuation criteria and

methods commonly accepted by academics and
professionals.

Types of calculations (expected value)

Estimating the river by estimating its future water flow.


A common practice in financial mathematics is:

to discount the chain of expected cash flows, by using a return rate
   that takes into account
the cost of money (interest rate) and the various
   market risks
.

to do it on various cash flow scenarios, applying a probability to each
   one
.

The weighed average of those various values is the mathematical
expectancy
of value or, to use simpler words, the expected value:

See the "expectancy" glossary article for a calculation
           sample.

Are such calculations reliable?

The value of previsions
and the value of the recipes to mix them.
Ready for the tasting?


That calculation will entail some subjectivity
(well, the market price is also partly subjectivity-driven), as:

1) Scenarios and probabilities are needed, as seen

above, to estimate the firm's economic prospects and risks.

But each agent either makes its own (subjective) projections and give its
(subjective) probabilities.

This is in the best case, as it is often (subjectively) contaminated by the
(educated?) "consensus" of others.

2) The calculation method to process those projected data can be a personal 
   
model, one's own cooking recipe.

But usually it reflects the current valuation paradigms, as consensual
methods admitted at the time of the valuation among financial experts
(thus submitted to obedience to experts, peer pressure, herding...).

=> About those reliability and relevancy issues,

see also the "value puzzle", "fair value" and "extrinsic value"
articles

Note: accounting aspects:

Modern accounting rules incite to use a " fair value" for assets and liabilities. It is

* either the current market price ("mark to market")

* or the value determined by a valuation model that is supposed to match 
   market
behaviors ("mark to model")

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

(extrinsic) Value


02/10i - 03/2d + see fair price,
fundamental analysis,
image
coefficient, value / valuation.

Seen from the outside.

Definition


We can call the extrinsic value of an asset the price that buyers and sellers
might
accept
when they make a transaction.

It is a potential price based on a knowledge of how the market behave (market
based valuation).

It might differ from:

the "intrinsic value" (see that phrase, and also "fair value", a near

equivalent) based on economic fundamentals.

Market prices rarely match fully that so called intrinsic value (which
can never be fully known, as based on economic hypothesis, as seen
below as well as in the related article).

Also, prices are affected by factors (including human biases) that are
exogenous to the economy
but endogenous to the market.

the current price also.

Let us start with the "intrinsic value" (see "value")

Econ inside

In theory, you can estimate a fair or "intrinsic" value for a stock with a

computation that uses only the fundamentals.

Fundamentals (see that word) are elements that are endogenous to:

The current as well as the predicted state of the economy ,

The current and predicted economic situation of the firm .

    See "fundamental analysis" about this.

Of course there is no certainty, when computing an intrinsic value,
that it reflects
realities. This is because:

The information about fundamentals is rarely perfect,

To deduce future prospects from past and existing fundamentals
    is
rather tricky,

Methods of evaluation (in other words, the ways to select,

process and combine those fundamental data) are diverse,


The estimate cannot be completely objective, even with the
    best-thought criteria.

This is the case for anything which is in the realm of "soft topics"
(economics is one) and is filtered by the human mind.

From the intrinsic value to the extrinsic value

Opening the windows.

As seen above computing an intrinsic value cannot be trusted fully as a potential
market price.

But it gives at least some tentative rational approach when buying or
selling an asset.

The question is, how to bridge intrinsic and extrinsic values, so as to calculate
a potential market price, to be your estimate of the "extrinsic" value?

This supposes to take into account the   predicted
     market biases 

(via the "stock image coefficient" for example, see that phrase).

See also the "valuation" and "value" article for details.

 

 

Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Value investing / value stock

Value invest. page

Value puzzle


See valuation, value, fair
price, fundamental analysis,
mispricing

Can price and value meet together happily?

What puzzle?

The value puzzle is that the fair (= theoretical, as seen above)
values,
even if they take into account the current paradigms,

may differ widely from the current market price.

Considering the value as something else than the price, see the paradox ?

But it becomes understandable when we think that market prices, as well as
valuations,result both from human interventions
.

Thus both of them mix subjectivity and rationality.

What anybody who makes a valuation should humbly admit is that:

Value is a virtual / potential concept, and its relevance

can be discussed endlessly,

While price, whatever its vagaries, is a real-life one

at least for stocks that are listed and have an active market).

Thus, is it useful to make valuations?

As we already have hard boiled prices,
in what softly cooked valuations can help?


Even if price is the objective information (in highly liquid markets), it is advisable
to estimate values. Whatever meaning is given to value:
theoretical, fundamental, fair, potential....


This is because:

The difference between the actual prices and the calculated values
    could help detect
some behavioral market biases (mispricing) and thus
    to spot potential 
price opportunities.

Bridges can be found between values and prices.
    Here we have a market-based valuation.

For example, the stock image concept (see image coefficient) could
help estimate potential prices by simulating market behavior.

It brings a crossover that mixes fundamental valuation and behavioral
valuation
.

Value stock

Value invest. page

Value trap

Value invest. page

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This page last update: 20/08/15  

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