Question

^{The lecture told us regarding the stock valuation. Could you explain what the practical problems in the stock valuation are?}

Answer 1

Stock valuation or Equity valuation is a way of assessing the fair value of a stock/security. There are many methods for Stock Valuation viz. Discounted Cash Flow (DCF), Relative Valuation, Balance sheet methods etc.

These methods are helpful in setting up a generally acceptable fair value for the stocks or the company and can be also used in equity research through which we can identify the undervalued or overvalued stocks. It to a certain extend can tell us the risks associated with the stocks.

Yet, these methods has below mentioned disadvantages.

• Problems in identifying the correct assumptions: Methods like DCF is based on finding the valuation by projecting future cash flows and discounting it to present value to find out the valuation which needs many assumptions like assuming the growthrate of the company, cost of capital etc. Hence identifying an accurate parameter will be difficult and due to this valuation tends to go in a range rather than an exact number.
• Dependend on market conditions: Methods like Relative valuation uses the current market condition like EBITDA multiple for valuing the company. This wont consider the entire risk of the company rather consider only the current performance of the company while valuation.
• Different methods provide different value of the company, which make an analyst difficult in choosing which value to follow. It gets even more difficult if each method results in a different value, and analysts must decide which value to follow. For example, in case of a start-up as per book value method, equity value will be low as it is unstable, but it can have good valuation as per DCF because it is in the high growth stage and project good future cash flows.
• Stock valuation methods ignores intangible assets of the company while valuing the stocks. Intangible assets such as brand loyalty, customer satisfaction, patent rights etc which can make significant impact for a company in terms of future growth are ignored.