Aswath Damodaran, a prevalent Professor at New York Business School, believes that there are 3 basic types of valuation. Intrinsic, relative, and option pricing valuation. Analysts use any of these types of valuations to calculate price estimates for any stock. Within these categories, there are multiple tools analysts can use to process the information.
All these valuation techniques assume that the market may be wrong. The current price of the asset may not reflect its estimated intrinsic value. A stock may be overvalued or undervalued depending on the results gathered from the valuation model. So, if you believe in Efficient Market theory, this post isn’t for you…
Still, here is where the problem lays. Most of Wall Street eagerly awaits each analyst report. Once these reports come out, investors take the information the analysts provide to buy or sell stocks. This is all good and fine but for one aspect. Valuation models, specifically intrinsic and relative models are supposed to be used in a long-term basis. When I say “long term” I mean a multiple year horizon. Investors make a huge mistake when they buy and sell stocks in a short-term basis. Since these valuation models assume that the market is wrong, they also assume that the market will eventually price assets accordingly over time. Sadly, this isn’t a guarantee. The market can remain mispriced for extended periods of time. There is no guarantee the market will ever price the asset according to its estimated intrinsic value.
An analyst may appear to be wrong. His/her estimates may come off as faulty and may cause many people to lose money in a short-term. As a result, the analyst will go back and adjust the model to fit the consensus view. This is natural because he or she may be in trouble if they continue to publish unprofitable analysis. Unfortunately, the initial analysis will be lost, and its initial accuracy sacrificed. Perhaps this analyst was right to begin with, perhaps not, but the point remains that Wall Street’s obsession with short-term trades does not permit investors to let the thesis play out.
In conclusion, wall street analysts make their reports using various valuation techniques. The technique itself isn’t necessarily relevant. It is how these reports are used that counts. You wouldn’t use a hammer to perform brain surgery, just like you shouldn’t use an analyst report to make short-term investment decisions.