Question

We probably have all seen various stock analysts and investment professionals on various business shows on television arguing over whether a particular common stock is undervalued, overvalued, or correctly valued. For the sake of discussion, assume that all of these analysts and investment professionals all use the same common stock valuation approaches discussed in this week’s material. Why might they still disagree on their valuation assessments? Do you believe they have any incentives to suggest that they can successfully identify undervalued common stocks? Finally, assume that your analysis suggests that a stock is correctly valued. Would such a stock be a good addition to your investment portfolio? Try to integrate Risk and Return in developing your answer.

Answer 1

It is quite possible for the stock analyst and the investment professionals to have different conclusions regarding their valuation assessment for a particular common stock and this is due to different return and risk expectations for that stock. A set of investment professionals may have higher return expectations from the stock and hence may perceive considerable upside for the stock and thus consider the common stock to be undervalued. While another set of analyst may have a divergent view and may consider the stock to be less risky and hence they may have lesser return expectations and may perceive the current price to be on the higher side.

They definitely have an incentive to claim to identify successfully the undervalued stocks as that would mean investors who invest as per their recommendations have a higher chance to gain once the undervalued stocks rise in value to their correct value and this would mean more number of investors seeking their advice and they can earn through consulting fees.

Even when a stock is correctly valued, it still makes sense to add to the portfolio to reduce risk through diversification and also on the premise of adding defensive stocks to the portfolio to hedge against economic uncertainty.