A better way to approach stock valuation

The value of a security should be determined via an actuarial process that strips out any and all vague and ambiguous information.

Mauroforlin, Shares

2022-01-27 07:05:00 PM

[ADVISOR VIEW] The value of a security should be determined via an actuarial process that strips out any and all vague and ambiguous information: MauroForlin - GlobalLocalZA. Shares Investing

The value of a security should be determined via an actuarial process that strips out any and all vague and ambiguous information.

The art of valuationThis is the crux of the problem. When an analyst approaches a valuation, he or she will almost always have bias, whether they know it or not, towards having the model reach a certain conclusion. The stock investor wants to find stocks to buy, so the natural tendency is to be optimistic about the company’s prospects. In more egregious situations, the investment banker has a monetary incentive, perhaps, to reach a valuation that supports the deal he or she is working on.

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What drives the value of a stock? When someone gets behind the wheel of a car for a long drive, whether they realise it or not, they are conducting a valuation exercise. This is because their speed is discretionary, and there are costs and benefits to the speed chosen. While speed limits vary, generally speaking, all drivers have the choice to break the speed limit and by how much. On the one hand, some prefer to drive to the speed limit (and that’s fine, as long as they stay in the lane to the right). On the other hand, it’s unrealistic to think one can exceed the limit by 40 kph the entire journey without receiving a ticket. So the decision centres on the probability of a speeding ticket and the magnitude of the ticket in rands, relative to how each additional kph increase impacts the time saved. Obviously, this process is imprecise. Apart from the natural uncertainties, such as a cop’s demeanour or local speeding tolerances, there are longer-term financial uncertainties such as the impact on insurance rates. Therefore, many “play it safe” by going approximately 10 kph over the limit because that is an acceptable risk. These are the cost-benefit decisions people make on a daily basis. But what about similar judgments in their investment portfolio? The art of valuation Compare this to the valuation of a stock, which also focuses on the most easily obtained data and works in most situations but carries with it a great deal of uncertainty. Just as a cop, unbeknownst to the driver, might need to meet a month-end quota or local ordinances might compel the officer to pull the driver over, a stock might carry with it idiosyncratic risks unseen to the investor. An unexpected increase in insurance rates could sting a lot worse than expected, as could a sudden decline in company sales. It is for these reasons that valuation is more art than science. Though it may seem to be scientific because it employs numbers and complex models, those things are not valuation themselves. A person must interpret the numbers, and a person must build the model. And these people, quite obviously, are human and subject to human behaviour biases. Perhaps more worrisome is that many of the numbers in a model are nothing more than a person’s educated guesses about the future, thus introducing uncertainty into the model. As typically utilised, these guesses are completely at the discretion of the analyst. This is the crux of the problem. When an analyst approaches a valuation, he or she will almost always have bias, whether they know it or not, towards having the model reach a certain conclusion. The stock investor wants to find stocks to buy, so the natural tendency is to be optimistic about the company’s prospects. In more egregious situations, the investment banker has a monetary incentive, perhaps, to reach a valuation that supports the deal he or she is working on. Consider a typical discounted cash flow (DCF) valuation. In a conventional DCF, the analyst will carefully calculate the discount rate, (even though it can be easily manipulated), project future cash flows, (even though they are merely guesses), and decide upon a terminal growth rate, (even though only slight changes in it can have a huge impact on the output of the model). Between these three discretionary components of a DCF model, the analyst largely has the ability to reach any conclusion he or she should desire. This may happen deliberately, as in the case of the investment banker trying to close a deal, or subconsciously, as in the case of the investor desperate for a stock to buy. Saying this process involves some imprecision may in fact be generous. The imprecision that comes with DCF valuation largely centres around growth. Simply adjusting assumptions about future growth can allow the analyst to reach wildly different conclusions. Perhaps, then, the goal should not be to best predict the future but rather avoid predicting it – or making any other unnecessary assumptions – and focus on what does not have to be guessed. Different road, same destination Of course, other approaches to valuation abound as well. These can usually be classified as “relative” valuation techniques and involve the use of ratios such as price-to-earnings, price-to-ebitda, price-to-sales, and so forth. Unfortunately, the problems with relative valuation include all of the problems of DCF valuation and then some. In reality, relative valuation is simply a shortcut to DCF valuation but introduces even more imprecision. In using the ratios – sometimes called multiples – of peer companies to infer what type of ratio is appropriate for the company being valued, the analyst is impounding a tremendous amount of bias regarding how favourably or unfavourably the company compares to its peers. If the analyst likes the company, he or she will want to assign it a higher multiple. That is the danger. Giving in to biases when performing a valuation is often inescapable because it is, typically, more art than science. The secret to better valuation, therefore, is to remove the artistic component. Rather than guessing about the future, use discretion and rely on what is known. There is a better way. When conducting valuation, it is imperative to remember the enormous amount of uncertainty but also the bias that comes from the human conducting it. This is because, when an analyst is biased, consciously or subconsciously, the variables driving the output become more subject to the analyst’s opinion and less accurate. The key, therefore, is to avoid bias, avoid human behaviour and focus on what is known. What do we know for sure? One thing that is known with complete precision is the stock price. We observe it and can watch it change continuously in real-time. But stock prices are not arbitrary. They all have meaning, and the most important meaning they have is the growth that each stock price implies. Thus, by focusing on this one piece of precise information, the stock price, and solving for what would otherwise need to be assumed, the growth rate, we can circumvent nearly all the problems mentioned above. Value judgments are a part of life. Each of us has the option to honk at the slowpoke in the left lane or to go 20 kph over the speed limit because we’re in a hurry. But we also have to be prepared for the consequences. Judgments should have no place in valuation, however. If not, the speedometer on your investment portfolio might be notching much slower gains than you anticipated. Andy Kern is a senior portfolio manager at New Age Alpha on which this article was first published here About Us At Global and Local Asset Management we firmly believe in stripping out all vague and ambiguous information from the investment process. Which is why we use New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). The H-Factor measures the probability a company will fail to deliver the growth implied by the stock price. This risk is caused by investors interpreting vague and ambiguous information and impounding it into a stock’s price in a systematically incorrect way. The lower the Human Factor, the more likely vague and ambiguous information has NOT been priced into the stock. The H-Factor System is a free comprehensive portfolio tool that enables investors to apply our Human Factor metric to over 6 000 stocks, ETFs, global indexes, and their own portfolios. New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to protect investor portfolios against this idiosyncratic risk caused by human behaviour. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behaviour. Through New Age Alpha’s research, they have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to their investment approach, they have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behaviour. If you would like to know more about how the Human-Factor score tool works and how we “Avoid the Losers”, then please contact us at Global & Local Asset Management. Disclosures Global & Local Investment Advisors (Pty) Ltd is a registered financial services provider in terms of the Financial Advisors and Intermediary Services Act (FAIS). Global & Local Investment Advisors (Pty) Ltd holds FSP license number 43286. Global & Local Asset Management (Pty) Ltd. Reg. Number: 2018/580284/07 Global & Local Asset Management is an authorised juristic representative of Global & Local Investment Advisors (PTY) Ltd FSCA License Number: 43286 Any investment performance figures quoted herein are for illustrative purposes only and should not be construed as investment advice. Investment advice can be provided by Global & local Investment Advisors (Pty) Ltd but only after an analysis has been conducted of the investor’s current financial circumstances and investment portfolio, only then will a recommendation be provided based on that investor’s own circumstances by Global & Local Investment Advisors (Pty) Ltd. New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC, New Age Alpha Advisors, LLC (“New Age Alpha Advisors”) and New Age Tau, LLC. Investment advice is offered through New Age Alpha Advisors, LLC a wholly-owned subsidiary of New Age Alpha LLC. New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements. Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or strategy made reference to directly or indirectly in this firm overview, will be profitable or equal to corresponding indicated performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Returns for one year or less are not annualised but calculated as cumulative returns. No client or prospective client should assume that any information presented in this firm overview serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. Any charts, graphs or tables used in this firm overview are for illustrative purposes only and should not be construed as providing investment advice. Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented has been calculated by applying each Index strategy backwards in time and is not a contemporaneous record of actual assets managed by New Age Alpha. All New Age Alpha trademarks are owned by New Age Alpha LLC. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (SPFS). All other company or product names mentioned herein, including S&P®, are the property of their respective owners and should not be deemed to be an endorsement of any New Age Alpha product or strategy. This firm overview is limited to providing general information about New Age Alpha and its investment advisory services. It is for informational purposes only and should not be construed by a client or a prospective client as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice. New Age Alpha’s specific advice is given only within the context of its contractual agreements with each client. Investment advice may only be rendered after the delivery of Form ADV Part 2 (an investment advisor’s disclosure document) and the execution of an investment agreement by the client and New Age Alpha. New Age Alpha’s Form ADV Part 2 and descriptions and summary annual reports or its composites are available upon request. jQuery(document).on('click', 'a[href*="#to-comments"]', function(event){ event.preventDefault(); jQuery('html, body').animate({ scrollTop: jQuery( jQuery.attr(this, 'href') ).offset().top }, 500); }); jQuery(document).ready(function() { /* The following handles lightbox expansions of images in the article */ var lightbox_path=lightbox_path||"";!function(a){a.fn.lightBox=function(b){function d(){return e(this,c),!1}function e(c,d){a("embed, object, select").css({visibility:"hidden"}),f(),b.imageArray.length=0,b.activeImage=0;var h,e=!1;if(b.grouping&&(h=c.getAttribute("rel"))&&(e=d,d=[],e.each(function(a,b){h==b.getAttribute("rel")&&d.push(b)})),1==d.length){if("gallery"==b.captionPosition)var i=jQuery(c).parent().next().html();else var i=c.getAttribute("title");b.imageArray.push(new Array(c.getAttribute("href"),i))}else for(var 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