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
* 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