Investors Beware: Equity Valuations Are Only Relative Equity Valuation: Science, Art or Craft?

05 Feb

Equity Valuation: Science, Art or Craft?

CHARLOTTESVILLE, Va.Feb. 5, 2018 /PRNewswire/ — Investors don’t want to pay too much for their investments, but can they really know if the actual market price of a stock — or of stocks in general — is fair value? A new publication by the CFA Institute Research FoundationEquity Valuation: Science, Art or Craft?, addresses this question, not only for listed stocks but for hard-to-value stocks such as initial public offerings (IPOs) or private equity.

The new study, co-authored by Frank FabozziSergio Focardi, and Caroline Jonas, is based on a review of recent research and interviews with asset managers, chief investment managers at major pension funds and academics in North America and Europe. The authors note that the current price level of stocks is a concern especially as the U.S. Federal Reserve has announced that it will be unwinding quantitative easing, and other central banks considering similar moves.

The price at which a stock is traded in the market reflects the ability of the firm to generate cash flow and the risks associated with generating the expected future cash flows. The authors point to the limits of widely used valuation techniques, the most important of these being the inability to forecast cash flows and to determine the appropriate discount rate. Another important limit is the inability to determine absolute value. Widely used valuation techniques such as market multiples — the price-to-earnings ratio, firm value multiples, or a use of multiple ratios, for example — capture only relative value, that is, the value of a firm’s stocks related to the value of comparable firms (assuming comparable firms can be identified).

The study underlines additional problems when it comes to valuing IPOs and private equity: both are sensitive to the timing of the offer, suffer from information asymmetry, and are more subject to behavioral elements than is the case for shares of listed firms. In the case of IPOs, the authors discuss how communication strategies and media hype play an important role in the IPO valuation/pricing process.

Because widely used valuation techniques cannot determine absolute value, the authors note that the techniques fail to inform if an entire market or segments of the market are overvalued, potentially leading to the mispricing of risk and large losses for investors. The authors note that the price-to-earnings ratio of S&P 500 firms is now 65 percent to 70 percent higher than during the period 1935-1995 as measured by the cyclically adjusted price-to-earnings ratio — a figure reached only before the Crash of 1929 and at the height of the dotcom bubble. Part of the high valuations might be a reflection of improved profit margins or other factors. For example, compared to the pre-1997 period, the margins of S&P 500 firms have risen by about 30 percent.

Determining if stocks are fairly priced would imply determining if there is an excess/dearth of demand for investments. The study points to the demand created by central banks’ policies following the 2007-2008 financial crisis, including quantitative easing and low to negative interest rates, as well as to a dearth of shares now in public markets. Quantitative easing by the U.S. Federal Reserve added $4.5 trillion in liquidity to the market; the European Central Bank added another €1.7 trillion, to cite actions of only two central banks.

In the U.S., the dearth of shares in public markets has been attributed to a combination of delistings coupled with a low rate of new listings and share buybacks. A 2015 study by the National Bureau of Economic Research identified a U.S. “listing gap”: The number of listed firms declined from a high of 8,025 in 1996 to 4,101 in 2012 (the figure was around 4,300 at the end of 2016). As for share buybacks, by some estimates U.S.-listed firms spent $6.1 trillion buying back their own shares during the 11-year period 2005-2016. Ultimately, the price of an asset is established by supply and demand.

The study also discusses the growing role of big data and new analytical methods in fundamental analysis and the future of active management, including an eventual expansion of their mission in helping asset managers to outperform the market.

Notes to Editors

Title: Equity Valuation: Science, Art or Craft?

Authors: Frank J. Fabozzi, Professor of Finance, EDHEC Business School; Sergio M. Focardi, Professor of Finance, Pole Universitaire Léonard de Vinci Research Center; and Caroline Jonas, Managing Partner, the Intertek Group, Paris.

Available in paperback from the CFA Institute Bookstore; or as an e-book from CFA Institute using the following link: https://www.cfapubs.org/toc/rf/2017/2017/4

About the CFA Institute Research Foundation

The CFA Institute Research Foundation is a not-for-profit organization that sponsors independent, in-depth research on current issues important to investors and investment professionals around the world.

About CFA Institute

CFA Institute is the global association of investment professionals that sets the standard for professional excellence and credentials. The organization is a champion for ethical behavior in investment markets and a respected source of knowledge in the global financial community. Our aim is to create an environment where investors’ interests come first, markets function at their best, and economies grow. There are more than 150,000 CFA charterholders worldwide in 165+ countries and territories. CFA Institute has eight offices worldwide and there are 149 local member societies. For more information, visit www.cfainstitute.org or follow us on Twitter at @CFAInstitute and on Facebook.com/CFAInstitute.

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