Limitations of Behavioral Finance
The theory of behavioral finance has become exceedingly popular in the past few years. This is largely because of the fact that it mixes the dry, numerical subject of finance with the interesting world of psychology. Most people who read about biases described in behavioral finance books often have a “me too” moment. The biases […]
Proof of Work Mechanism in Cryptocurrency
Investors who are new to cryptocurrencies tend to find the entire ecosystem confusing and deceptive. When investors try to educate themselves on topics related to cryptocurrencies, they feel like they are attending more of a technical subject course instead of learning about finance. This is the reason why traditional investors have been avoiding cryptocurrencies for […]
Pension Funds and Fiduciary Duty
Whenever investors pool their resources together in order to create a fund that then invests in other assets, the concept of fiduciary duty comes into play. The average investor considers fiduciary duty to be a complex legal subject and hence tries to avoid delving into the details. However, the subject is not very complex. Also, […]
Issues With Sponsorship Levels
In the previous article, we have already seen what sponsorship tiers or sponsorship levels are. We have also seen the various benefits that such a sponsorship arrangement can provide to both the sponsor as well as the sponsored sports entity. Hence, we know why sponsorship levels are widely used as a financing arrangement across various […]
Hedge Funds and Regulations
Technically, the term hedge fund does not exist. In fact, the term hedge fund applies to any fund which is sold to accredited private investors and does not have to follow through with the regulation process! Now, investment advisory is a highly regulated industry and there are several laws which have been passed to ensure […]
Estimating the value of equity stock of a company is not an easy proposition. This is because while estimating the stock price, all the data required to be used in the formula is not easily available. This is because the data is subjective.
It is really the analysts call on what they believe about the company, its future and based on it what numbers they input in the formula.
Also, slightly different numbers used in the formula give vastly different results. Hence, an analyst must have a strong basis to use any number as an input to the stock valuation formula.
Here are some of the common assumptions that will have to be made by the analyst during the stock valuation exercise:
As we learned in the previous article that stock valuation happens in two stages. The first stage is the horizon period for which exact cash flows are estimated.
Beyond the horizon period, the stock is considered to be a growing perpetuity and its value is estimated. But the question is “How big or small should the horizon period be and why?” We need to understand that the answer to this is not factual or based in proof.
Rather, the answer is based on subjectivity and convention. It is therefore entirely up to the analyst to decide what the horizon period should be?
An investor, however must be aware that changing the horizon period has massive effects on the stock valuation and must therefore watch out for the same.
After the horizon period is over, the stock is considered to be a growing perpetuity. This means that it will continue growing at a constant rate for the rest of its perpetual life.
This rate must be less than the required rate of return or else the answer we will receive will be infinite since it will no longer be a decreasing infinite series.
But, then what should that constant rate of growth be? This is again a matter of great subjectivity. Once again the analyst has a high level of discretion in this decision.
Also, this assumption is extremely important because the value of the perpetuity accounts for almost two thirds of the stock price in most cases.
A wrong assumption here can therefore give a significantly higher or lower stock price.
Apart from the expected returns to be realized from the venture, there is also a great deal of subjectivity regarding the riskiness that is involved in each case. It is obviously difficult to compare the riskiness across industries and across companies.
It is for this reason that estimating the cost of capital becomes relatively difficult. The market is efficient in pricing risk to a large extent.
The cost of equity capital is calculated using data from the market from the past few years. But once again, the riskiness can be very different depending on whether we select data for the past 10 years or for the past 15 years. This makes it a subjective decision too!
Also, the cash flows in the horizon period are estimated based on what the analyst thinks the future looks like in the next 5 to 7 years or whatever is the chosen horizon period. But, it is important to know that these estimates rarely end up being accurate.
Consider the fact that business cycles are largely unpredictable, and so are the moves by the competition and we understand why we can’t be relatively certain even about the future in the short and medium term.
The bottom line therefore is that any stock valuation is like a building which is standing on the pillars of its assumptions.
A good investor will therefore first investigate the soundness and reasonableness of its assumptions before deciding whether or not the stock valuation is fair.
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