I been suffering with my studying lately because I cannot accept ideas that I do not view to be correct in equity valuation. The biggest problem I have is with the discount rate; none of the models we study are flawless and thus so are our valuations…Of course there are many other issues. Today, after doing some readings I decided to let it go. If it is how the market is valuing a stock then even if the method is wrong, as almost as we can use superior inputs that the market has not seen yet, we can predict how the market will price it even though the market is not using sound methods. This quote by Keynes sums it up for me “Stock valuation is not an estimate of the fair value of stocks, but rather a convention, which serves to provide the necessary stability and liquidity for investment, so long as the convention does not break down” I just want to see what you all think about it. Do you see it as a solid science? I especially care to see the opinion of people who actually work in ER. I also would like to be directed to other readings that discuss the issue…

Can you put all that rambling into a clear thought?

Or a clear thought into that rambling?

@gulfcfa, That’s why firms have proprietary models. They don’t just use what’s in the book; they develop their own.

Yeh guys, communication skills on AF if not one of my strengths. I just tend to type what is going on in my head. But then again one guy managed to get what I am talking about. So he has the skill of understanding people who have no communication skills. That’s gota be worth something in the workforce… @Zesty, you wana put me as a reference on your resume?

regardless of how well Zesty thinks he understood, you certainly aren’t going anywhere without decent communication skills in the workforce

Remember, a valuation of a stock is only your best guess at its intrinsic worth (a pretty arbitrary concept). There is no one “right” way of doing it. So certainly not an exact science.

He is saying that the reason that equity valuation might work is that everyone uses the same method, which they learn from each other, and not because that it is scientifically correct.

exactly @ohai That is what i buy into. I think cfa curriculum should touch more on the weaknesses of the methods. I am fresh out of school and i can write a book about flaws…i am sure a million phds are working to find somethin better

exactly @ohai That is what i buy into. I think cfa curriculum should touch more on the weaknesses of the methods. I am fresh out of school and i can write a book about flaws…i am sure a million phds are working to find somethin better

Wait wait…so you have studied a theoretical model that is FLAWLESS??

I always find it amazing the number of people who think. (use of math to describe something) = (science) Valuation methods are always “approaches to valuation,” not the “true value” of something. Even when there is math involved. The only reason arbitrage seems to offer a “more scientific” valuation approach is because it increases the number of ways to value assets, specifically, it allows you to value an asset in terms of the value of other assets (including or not including cash). The only reason it works (when it does), is that replicating portfolios are tied to each other in a particular way that may be independent of the cash value of any part of it. However, the value of cash vs any asset (other than cash itself) is inherrently uncertain, because it depends on so many unmeasurable or difficult-to-measure things (like people’s preference for present vs future consumption, risk tolerances, what the relevant risks are, the volatility of volatility, etc.). So yeah, the CFA actually does test you on what the strengths and weaknesses of various model assumptions are, but they also want to make sure you know how to use a particular model if you have decided that that’s the best approach for a particular problem.

Seth Klarman has a great interview where he describes valuing a company. I’m paraphrasing here, but it’s something like: “So people trying to value a company down to the last penny - “It should be worth $5.43 exactly” - are fighting a losing battle. Think about your car - it’s got hundreds, maybe thousands of moving parts, its history is unique, the market you’re selling it in is unique, and so on - and you don’t try to come up with an exact price tag for it. Instead, you come up with a range of what’s probably fair for it, and you sell it for somewhere in that range if you can.” Conversely, if we’re looking at a company based on the different price tags we use - price to cashflow, price to book, price to earnings, price to EV, and so on - and it appears to be at the ‘low range’ of all of them, well then, it’s probably interesting to us." And I think Warren Buffet said something like, “We’re looking for mispricings that are easy to spot. If a 350 lb man walks in the door, you don’t need calipers and a scale to determine he’s overweight. Conversely, if you’re computing the value of a company out to three decimal places and predicting cashflows out to forever in order to feel comfortable about investing, then the company is probably not at a price worth bothering with.” I think these two quotes are not a bad way to think about valuation in general. The models that the curriculum teaches are fascinating in a theoretical sense, but if the only way you feel comfortable investing is when DDM or GGM says a company is precisely 10% undervalued with your inputs, that’s probably not even an investment worth screwing around with. If almost any metric you can choose says that a company is probably severely undervalued, even allowing for a range of scenarios, then the investment is probably at least worth considering.

The current value of a common stock share equals the price for which you can sell it currenlty. The value of a common stock share in one year equals the price for which you can sell it one year from now. The human factors are what make this whole game so hard. As pointed out above, the valuation model is relevant to the extent that investors care about it at that time. Understanding different valuation methods is useful for understanding different investor perspectives on a company. There is no silver bullet, but their is often a *more* correct way to analyze a company given the context.

Awsome guys, thanks for all, and esp for the guys who put an effort into explaining… @bchadwick said "I always find it amazing the number of people who think. (use of math to describe something) = (science) " I sure was one of those people. Hek I thought the CFA curriculum would teach me to value stock to the nearest cent so that if the model tells me it should be 5.00 and it is selling for 4.99 I should buy it! Loooooooooooooooool Slowly but surly my view is changing. I am starting to accept that a lot of things cant be truly quantified…after all models are only “models” again thanks guys, you are great

Some good comments above, so I’ll try not to repeat and comment from a more macro level. Valuation is, in many ways, trying to predict the future, which makes it inherently difficult to do with any exactness. Markets are a discovery device, they discover information and transmit it in the form of a price. Are those prices always “correct”? Maybe so at a given moment, but the world is pretty dynamic. The Chicago Board of Trade discovers the price of corn every day. There are millions of different potential producers and consumers in the world. Each consumer has their own set of unique values - how much they will pay for what, at what price they will turn to substitutes and which substitutes they will turn to, and under what conditions they will do without. Each producer has a unique set of costs - different production technologies, and options under differing conditions - how much they are willing to produce at each different level of costs. The market finds information that exists in the collective mind in society, but not any single mind. Every day things change, every day you have to find the price. There is simply no model that can reasonably be expected to factor in each of these variables, much less predict the aggregate outcome of millions of individual choices down to the 3rd decimal.

I like to think of it in the following way: “There’s no arguing with the market in the present. The market is ‘the truth’ about the present, at least in terms of prices. But it’s only a ‘mob’s best guess’ about the future. Your guess may be better than the mob’s, but just be aware that the mob is large, and likely knows a lot of information that you don’t, so don’t fool yourself into thinking that it’s easy to outsmart the mob. And it’s almost impossible to outgun the mob. Unless of course, you ARE the mob. If you are the mob, then it’s almost impossible to outperform yourself, but it is possible to coerce others into paying you.” Gee… this mob analogy works really well.

bchadwick Wrote: ------------------------------------------------------- > I like to think of it in the following way: … Gee… this mob analogy works really well. …and who is there to help mobs fight each other in their battles over valuation - the lord of war, who stockpiles weapons of the trade and holds no opinion on right/wrong. Then again you may find yourself, alone, in some sub-saharan country. Wait, what are we talking about again?

LPoulin133 Wrote: ------------------------------------------------------- >the lord of war Nick cage loses his sh!t really well in that movie…when he takes the coke and gunpowder and has sex with a possibly HIV infected prostitute.