Investors who want to maximize returns try to identify mispriced stocks, creating long opportunities for companies that are underpriced, and short opportunities for stocks that are overpriced. Not everyone believes that stocks may be mispriced, especially those who support the efficient market hypothesis. Efficient market theory assumes that market prices reflect all available information about stocks and that this information is uniform. These observers also believe that asset bubbles are driven by rapidly changing information and expectations, not by irrational or excessive speculation.
Many investors believe that the market is mostly efficient and that some stocks are mispriced at different times. In some cases, the entire market may be pushed beyond rationality in a bull or bear market, challenging investors to identify the peaks and troughs of the economic cycle. The market may ignore information about the company. Small-cap stocks are particularly prone to irregular information because there are fewer investors, analysts, and media sources who follow these stories. In other cases, market participants may incorrectly estimate the size of the news and temporarily distort stock prices.
These opportunities can be determined in several broad ways. Both relative valuation and intrinsic valuation focus on the company’s financial data and fundamentals. Relative valuation uses many comparative indicators to allow investors to evaluate a stock relative to other stocks. The intrinsic valuation method allows investors to calculate the value of the underlying business independently of other companies and market pricing. Technical analysis allows investors to identify mispriced stocks by helping them identify possible future price changes caused by the actions of market participants.
Financial analysts use several indicators to correlate prices with basic financial data. The P/E ratio measures the price of stocks relative to the company’s annual earnings per share (EPS). It is usually the most popular valuation ratio because earnings are critical to determining actual value. The underlying business provides earnings. value. Price-to-earnings ratios are usually calculated using forward earnings estimates, because theoretically previous earnings have already been reflected in the balance sheet. The price-to-book ratio (P/B) is used to show that the company’s valuation is derived from its book value. P/B is very important in the analysis of financial companies, and it is also useful for identifying the level of speculation in stock valuations. The ratio of enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) is another popular valuation metric used to compare companies with different capital structures or capital expenditure requirements. The EV/EBITDA ratio helps to evaluate companies operating in different industries.
Yield analysis is usually used to express investor returns as a percentage of the price paid for stocks, allowing investors to conceptualize pricing as cash expenditures with potential for returns. Dividends, earnings, and free cash flow are popular types of investment returns that can be divided by the stock price to calculate the rate of return.
Ratios and yields alone are not sufficient to determine mispricing. These numbers apply to relative valuations, which means that investors must compare various metrics between a set of investment candidates. Different types of companies are valued in different ways, so it is very important for investors to use reasonable comparisons. For example, growth companies usually have higher price-to-earnings ratios than mature companies. The medium-term prospects of mature companies are more moderate, and they usually have more debt-heavy capital structures. The average P/B ratios of different industries also vary greatly. Although relative valuation can help determine which stocks are more attractive than their peers, this analysis should be limited to comparable companies.
Some investors attributed the theories of Benjamin Graham and David Dodd of Columbia Business School to the belief that stocks have intrinsic value independent of market prices. According to this school of thought, the true value of stocks is determined by basic financial data and usually depends on minimal or zero speculation in future performance. In the long run, value investors expect market prices to tend towards intrinsic value, although market forces can temporarily push prices above or below that level. Warren Buffett may be the most famous value investor of our time. For decades, he successfully implemented the Graham-Dodd theory.
Intrinsic value is calculated using financial data and may include some assumptions about future returns. Discounted cash flow (DCF) is one of the most popular internal valuation methods. DCF assumes that the value of an enterprise is the cash it can produce, and future cash must be discounted to present value to reflect the cost of capital. Although advanced analysis requires more detailed methods, the balance sheet items at any given point in the continuing operation period only represent the structure of the cash production business, so the overall value of the company can actually be determined by the discounted value of the expected future cash flow.
Residual income valuation is another popular method of calculating intrinsic value. In the long run, the intrinsic value calculation is the same as the discounted cash flow, but the theoretical concepts are somewhat different. The residual income method assumes that the value of a company is the sum of its current net equity plus future earnings that exceed the required return on equity. The required rate of return on equity depends on many factors and may vary from investor to investor, although economists have been able to calculate the implied required rate of return based on market prices and debt securities yields.
Some investors give up analyzing the details of the underlying business of stocks and choose to determine value by analyzing the behavior of market participants. This method is called technical analysis, and many technical investors assume that market pricing already reflects all available information about stock fundamentals. Technical analysts predict future stock price trends by predicting future decisions of buyers and sellers.
By observing price charts and trading volumes, technical analysts can roughly determine the number of market participants who are willing to buy or sell stocks at different price levels. In the absence of major changes in fundamentals, the participants’ entry or exit price targets should be relatively stable, so technical analysts can find that there is an imbalance between supply and demand in current prices. If the number of sellers at a given price is lower than the number of buyers, then it should push the price up.