Let’s face it, price is a determining factor for most goods purchased. Therefore, price acts as a measure of quality. Generally, the higher the price the greater the quality perceived. But how do we determine the price of goods that we purchase?
These questions can be extended to the prices of stock exchange-listed shares.
I have decided to narrow my thoughts on, how shares are priced. We all know that the price displayed on each listed stock includes all the known information about the share. Any information that is unknown is considered as an immeasurable risk. Immeasurable risk if deemed material, has the propensity to either move the share price up or down unrealistically.
Regardless of what we know or do not know about the share price exhibited, let’s focus our thoughts on the following questions i.e. how is the price derived? How do we know that we are paying the correct price from an active investor’s perspective? To answer these questions, I am going to share with you some of the equity valuation models investment industry practitioners employ to justify whether the share price is undervalued or overvalued.
Traditional Valuation Models
Most celebrated models used to value and justify a stock price are: Discounted Dividend Valuation, Free Cashflows Models, Price and Enterprise Value Multiples such as the price to earnings ratio, price to book value, Enterprise Value to Earnings Before Interest Tax Deprecation and Amortizing (Ebitda) and the Residual Income Models.
The common denominator binding these valuation models is information. Additionally, these models are mostly used by active managers who treat the stated price with scepticism. Equity price valuations anchors on either agreeing with the displayed price or doubting that price. If valuations do not concur with the stated price, mispricing occurs which creates an arbitrage opportunity.
Below is a brief summary of each model:
Discounted Dividend Model
This model is largely based on the capacity of the company to pay dividends. This model works very well for stable mature companies with discernible growth patterns. The latest dividend is then forecasted into the future based on Top-Bottom, Bottom-Top or Hybrid approaches. The aim of this model is to check whether the price reflected on the stock market is relatively undervalued, fairly valued or overvalued. However, the main weakness of this model is the appropriate discount rate to use to obtain the value of the stock.
Free Cashflow Model
This model focuses mainly on the free-cashflow left after capital expenditures, an increase in working capital and debt payments. Additionally, this model is used when the company is unable to pay dividends or has weaker/negative earnings which might make the price to earnings unmeaningful.
Price and Enterprise Multiples
Price multiples are ratios of a stock price to a measure of fundamental value per share. Enterprise value multiples concern the total market value from all sources of the company’s capital to measure fundamental value for the entire company. To determine whether a stock is accurately priced, the multiple is compared to its peer-companies, overall industry in which the company operates and its own past. The main drawback of this model is that there might be no comparable company to make a relative decision, which will render the valuation useless.
Residual Income Model
This model analyses the intrinsic value of the company as the sum of current books value/ shareholder’s equity and the present value of expected future residual income. A company with a positive residual income is able to cover its cost of capital is adding value. Conversely, a company with a negative residual income is destroying value; this implies the company is unable to cover its cost of capital.
Based on these valuation models one is able to:
Determine whether the price the investor is paying is justified enough to generate growth by buying the share in question.
Away from the above-mentioned valuations methods, I have come across a model called the H-Factor model developed New Age Alpha LLC, a New York-based asset manager.
In my own opinion the above equity valuation models seem complicated to a novice investor or even an articulate investor relative to the H-Factor model I am going to explain below:
Non-Traditional Valuation Model
H-Factor Model (Avoiding the Human Error)
As mentioned above stock prices are moved by information. This information is affected by human biases which creates a risk that any investor is not going to be compensated for. This risk is called the human factor. This model asserts that humans tend to interpret vague or ambiguous information in an incorrect way thus creating a human error in stock selection.
The main thrust of this non-traditional model is to avoid the Human Factor by using an actuarial probability-based approach in stock selection with the aim of generating better returns and lower risk.
This model works with the known variables of the company which are stock price, market capitalisation and latest financial statements. At the core of this model are the price justification and the probability of the company to sustain that price by producing output that is equivalent to its market capitalisation. If the probability score is high, it means the company cannot wholly justify its share price. A lower probability score is more favourable.
The main advantage of this model is the use of actual information instead of forecasts and warm relationships an analyst can develop with a company they follow, thus creating a bias.
An example of the H-Factor price justification:
Suppose Company X a bread-making company has a share price of R50 and has 100 000 shares in issue. The market capitalisation is R5 000 000.00.
The number of bread loaves the company must sell to justify its share price is: 100 000 (R5 000 000/50).
Suppose Company X produces less than 100 000 loaves of bread due to operational concerns, the share price of R50 is not justified by the output produced, therefore the H-Factor model will assign a higher score. In that regard, the share price is expected to fall to match the output produced.
If Company X produces more than 100 000 loaves of bread, Company X is, therefore, justifying its share price of R50. A low H-Factor score is assigned.
“Avoid the Human Factor” model simply measures the ability of the company’s business performance to justify its current share price.
Valuations play a pivotal role in equity selection; therefore, one should understand the underlying assumptions of the model used to determine whether the current share price is under or overvalued in order to avoid immeasurable risks in a portfolio of shares.