Valuation is at the heart of any investment decision, whether that decision is to buy, sell, or hold. But the pricing of many assets has become a more complex task in modern markets, especially after the recent financial crisis. In order to be successful at this endeavor, you must have a firm understanding of the proper valuation techniques.
The role that valuation plays in portfolio management is determined in large part by the investment philosophy of the investor. Valuation plays a minimal role in portfolio management for a passive investor, whereas it plays a larger role for an active investor. Even among active investors, the nature and the role of valuation is different for different types of active investment.
Professor Aswath Damodaran, also known as the expert on valuation, is a professor at the NYU Stern School of Business. In his book Investment Valuation, Damodaran reveals the strategies of different types of investors and how they use valuation to help them make investment decisions.
⭐️ Fundamental Analysts
Fundamental analysts believe the value of a firm is related to its financial characteristics, such as growth, risk, and cash flows. If the price differs from this value, then the stock is either under or over-valued. It is a long-term investment strategy, and the assumptions underlying it are:
The relationship between value and the underlying financial factors can be measured,
The relationship between value and fundamentals is stable over time,
Any deviation between price and value is corrected in a reasonable amount of time.
Fundamental analysts will use discounted cash flow or multiples such as price-earnings or price-book to value companies. Since investors hold a large number of undervalued stocks in their portfolios, their hope is that, on average, these portfolios will do better than the market.
Investors using this approach will buy a large number of undervalued stocks in their portfolio in the hope that, on average, this portfolio will do better than the market.
Chartists believe that prices are driven as much by investor psychology as by any underlying financial variables. The assumptions here are:
prices move in predictable patterns,
there are not enough marginal investors taking advantage of these patterns to eliminate them,
the average investor in the market is driven more by emotion than by rational analysis.
While valuation does not play much of a role in charting, there are ways in which an enterprising chartist can incorporate it into the analysis.
⭐️ Information Traders
Prices move on information about the firm. Information traders attempt to trade in advance of new information or shortly after it is revealed to financial markets. Prices move when new information enters the market. For an information trader, the focus is on the relationship between information and changes in value rather than on value per se. Thus an information trader may buy an overvalued firm if he believes:
the next information announcement is going to cause the price to go up because it contains better-than-expected news.
If there is a relationship between how undervalued or overvalued a company is and how its stock price reacts to new information, then valuation could play a role in investing for an information trader. That means an information trader will buy an overvalued stock if they think new information will drive the price up.
⭐️ Activist Investors
Activist investors take positions in firms that have a reputation for poor management and then use their equity holdings to push for change in the way the companies are run. Their focus is not so much on what the company is worth today but rather on what its value would be if it were managed well. These investors have to ensure:
there is additional value that can be generated by changing management.
Activist investors generally concentrate on a few businesses they understand well and attempt to acquire undervalued firms. Often, they wield influence on the management of these firms and can change financial and investment policy.
⭐️ Market Timers
Market timers believe there are greater returns to be made by predicting the turns of the market rather than picking individual stocks. They believe there are factors that can be observed which make predicting market movements easier than selecting stocks.
While the valuation of individual stocks may not be of much direct use to a market timer, market timing strategies can use valuation in one of at least two ways:
the overall market itself can be valued and compared to the current level,
valuation models can be used to value a large number of stocks, and the results from the cross-section can be used to determine whether the market is over- or undervalued.
⭐️ Efficient Marketers
Efficient marketers believe that the market price represents the best estimate of the true value of the firm. They believe that the market collects and interprets information so quickly that stocks can never be over or undervalued.
For efficient marketers, valuation is a useful exercise to determine why a stock sells for the price that it does. The objective becomes determining what assumptions about growth and risk are implied in this market price rather than finding undervalued or overvalued firms.
Valuation in Portfolio Management
Valuation plays a key role in many areas of finance and in portfolio management. Valuation is not an objective exercise, and any preconceptions and biases that an investor brings to the process will find their way into the value. And even the very best valuation will yield an estimate of the value, with a substantial likelihood of you being wrong in your assessment.
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