Valuation : Question 12
What assumptions are relied on for stating that a security is under or over valued? What is the basis for assumptions that the market is anticipating a rise in share prices in a given sector, or even a rise in the stock exchange index?

Firstly, we should remember that on markets in equilibrium on which a sufficient number of changes take place, a share will be traded at a price that reflects all of the expectations of investors – it’s like a democracy! At this price, there will be as many investors who believe that the share is undervalued as investors that believe that it is overvalued, because if everyone thought that it was undervalued, there would be a rush on the share and the price would rise until the share was trading in equilibrium, i.e. where half the investors believe that the share is undervalued and the other half think that it is overvalued.

Having said that, it’s also important to look at share prices and markets objectively. We can calculate the implicit rate of return of a share or a market on a regular basis. This rate is determined on the basis of the share price and the flow of future dividends, as estimated by financial analysts. We then compare the theoretical rate of return that the shareholder is entitled to expect, given the risk of the share. Such calculations are regularly done by financial analysts and specialised firms. If the rate of return on the share price is higher than the theoretical rate of return, this is a sign that the share is undervalued. If the rate of return on the share price is lower than the theoretical rate of return, this is a sign that the share is overvalued.

Another technique involves trying to find a peer company (same country, same sector, similar future growth and risk) and comparing the multiples (P/E, rate of return) of this company’s stock with those of the company to be valued. This method shows whether a share is undervalued compared with another share at a specific time.

For more information, see chapter 40 of the Vernimmen.