Importance of valuation in portfolio management

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A principle of sound investing is that an investor does not pay more for an asset than its worth. A principle of sound investing is that an investor does not pay more for an asset than its worth.
SummaryEvery asset can be valued, but some assets are easier to value than others.

Every asset — be it financial or real — has a value. The key to successful investing lies in understanding not only what the value is, but also its sources. Every asset can be valued, but some assets are easier to value than others, and the details of valuation vary from case to case.

For instance, valuing a real estate property will require different information and different mechanics than that of publicly traded shares of a company.

Basis for valuation

A principle of sound investing is that an investor does not pay more for an asset than its worth. This is quite logical and obvious, but often it is forgotten . Basically, financial assets are acquired for the cash flow expected from them. So, perceptions of value have to be supported by reality, that is, the price paid for any asset should reflect the cash flows it is expected to generate.

Eliminate bias before valuation

Valuation is neither a science nor an objective search for true value. Most models used in valuation may be quantitative, but the inputs leave plenty of scope for subjective judgments.

Thus, the final value arrived is coloured by bias; so that the price gets set first and the valuation follows. The way out is to eliminate all bias before starting on a valuation, but this is easier said than done; the reason being that most investors are exposed to external information, analyses and opinion about a company.

But there are ways of reducing bias. The first is to avoid taking strong public positions on the value of a company before the valuation is complete. The second is to minimise, prior to the valuation, the stake investors have in whether the company is under- or over-valued.

Arrival of new information

The value obtained from any valuation model is affected by firm-specific as well as market-wide information. So, the value will change as and when new information is revealed.

The information may be specific to the firm, affect an entire sector, or alter expectations for all firms in the market. Information about the state of the economy and the level of interest rates affect all valuations in an economy. A weakening in the economy can lead to a reassessment of growth rates across the board, though the effect on earnings is likely to be the largest at cyclical firms. Similarly, an increase in interest rates will affect all investments,

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