Like practitioners of other trades, finance professionals are sometimes so entrenched in their own jargon that they can be unaware that no one else understands them. I was reminded of this fact by a non analyst colleague a couple of days ago: “This is likely one of the most recurring of your phrases when you talk about stocks: “Equities are fairly valued” or “equities are cheap.” Can you please explain to me what you mean by that? What kind of metrics or models do you use to come to such a conclusion? And how reliable is such a statement?”
Answering these questions would require a much larger space than a short note. For an in-depth treatment of this question, I refer to a small, easy-to-understand, but very substantive book, The Little Book of Valuation, by Aswath Damodaran, published recently by John Wiley & Sons.
Valuing an asset basically means estimating its intrinsic value and then comparing it with its actual price. If there is a significant difference between the two numbers, then the asset is said to be under- or overvalued. For exchange rates, for example, you can use the so-called purchasing power parity. Comparing the prices of goods (such as the Big Mac) or baskets of goods in two different countries and finding the exchange rate that would equalize the value of those goods expressed in a common currency is a valuation exercise.
For equities, more sophisticated models are often used such as discounted cash flow, profit or dividend models. Here, you assume that the equity of a company is a claim on all future cash flows, profits or dividends. By discounting them with an interest rate – as future cash flows have less value than present cash flows – you find the value of a specific equity. Obviously, to get to this number, you need to make assumptions regarding future cash flows, profits or dividends as well as interest rates. This is the job of equity analysts. Aside from this absolute valuation approach, you can also use relative valuation, where you would compare the value of a specific equity with its sector or regional peers.
The main problem with valuation is that it relies on future assumptions and forecasts, and could therefore be misleading if those assumptions and forecasts prove to be wrong. As investment legend Howard Marks once said: “An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”
This is why investment experts who use valuation as the main or even the single reason for an investment decision usually focus on valuation extremes, i.e., when an asset is highly over- or undervalued. This means such investors are usually seen as contrarians because, against market consensus, they will sell a highly overvalued asset and buy a highly undervalued one. It also means that they need patience. It can sometimes take years for assets to find their way back to their fundamental or fair value – remember the dot-com and US real estate bubbles – but, ultimately, they do.
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