Importance of valuation in portfolio management

Oct 15 2013, 17:43 IST
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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, of course, to varying degrees.

Underlying assumptions in valuation

Even at the end of the most careful and detailed valuation, there will be uncertainty about the final figure arrived as there are assumptions that one makes about the future of the company and the economy. It is unrealistic to expect absolute certainty in valuations. The degree of precision in valuation is likely to vary widely across investments. The valuation of a large and mature company with a long financial history will usually be much more precise than that of a young company in a sector in turbulence.

Quantitative models

not always better

There is a general belief that a valuation model that is more complex yields better valuations, but it is not necessarily so. When the models become more complex, the number of input variables needed to value the firm increases, thus bringing in the potential for input errors.

While engaging in more complex models, investors should keep in mind the following points: First, adhere to the principle of parsimony, which states that one should not use more inputs than absolutely needed to value an asset; and, second, that there is always a trade-off between the additional benefits of building in more detail and the estimation errors.

Markets are inefficient

The general assumption under an inefficient market is that it makes mistakes and investors can find these, often using information that other investors have access to. So, it seems reasonable to say that those who believe that markets are inefficient should spend their time and resources on valuation and those who believe that markets are efficient should buy the shares at the market price as the best estimate of value.

Those who believe that the market makes mistakes and buy or sell shares on that basis believe that, ultimately, markets will correct theses mistakes, meaning which they become efficient. Recognising that markets make mistakes and finding them requires a combination of skill and a bit of luck too.

To conclude, the role valuation plays in portfolio management is determined by the investment philosophy of the investor. Valuation plays a minimal role in portfolio management for a passive investor, whereas it plays a larger role for an active investor.

* The writer is an associate professor of accounting and finance in IIM Shillong

The process

* Basis for valuation: An investor should not pay more for an asset than its worth. So, the price paid for any asset should reflect the cash flows it is expected to generate

* Eliminating bias: 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. Avoid taking strong public positions on the value of a company before the valuation is complete. Minimise, prior to the valuation, the stake investors have in whether the company is under- or over-valued

* 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

* Assumptions: Even at the end of the most careful and detailed valuation, there will be uncertainty about the final figure arrived as there are assumptions that one makes about the future of the company and the economy. It is unrealistic to expect absolute certainty in valuations. The degree of precision in valuation is likely to vary widely across investments

* Markets are inefficient: The general assumption under an inefficient market is that it makes mistakes and investors can find these, often using information that other investors have access to. So, those who believe that markets are inefficient spend their time and resources on valuation and those who believe that markets are efficient buy the shares at the market price as the best estimate of value

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