It gets even more difficult if each method results in a different value, and analysts must decide which value to follow. It sometimes becomes difficult for an analyst to determine which method is suitable. There are multiple methods of valuing equity, and each method has a different perspective. Disadvantages of Equity Valuation Dilemma in Selecting a Valuation Method On the other hand, if the market undervalues most stocks, it is a negative signal.Īs we have seen about the advantages of equity valuation, let us see its disadvantages. If the market is overvaluing most stocks, then investors view the market positively, and the expectation from the market is good.
The idea is to arrive at the fair value of each stock and compare it with the prevailing market rates. This is when equity valuation comes to the rescue. Sometimes though, market signals may not be so clear, and investors might have confusion about the market direction. There are times when the market is bearish & then there are times when the market is clearly bullish. Furthermore, valuation is a key factor in assessing the fairness of a merger’s terms. Investors need to know whether that stock’s price is reasonable or not. Especially in mergers and acquisitions, buyers often use the company’s own common stock as currency for the purchase. Such events may affect a company’s future cash flows and thus the value of its equity. Investment bankers, corporate analysts, and investment analysts use equity valuation tools to assess the impact of corporate events, including mergers, acquisitions, divestitures, spin-offs, management buyouts (MBOs), and leveraged recapitalizations. This further helps analysts and investors make informed investing decisions. The analyst has to compare company ABC’s price-earnings ratio to the sector benchmark. There are even benchmark price-earnings ratios available for the sector. In that case, it becomes easy for the analyst to compare the price-earnings ratio of company ABC to the price-earnings ratio of its competitors. For example, suppose the price-to-earnings ratio is used for valuing the stock of company ABC. When relative valuation methods are used to determine the value of a stock, it becomes easy for the analyst to compare stocks within the sector and industry. When such factors are identified, investors and analysts can take precautions to avoid stocks that are a red signal for the portfolio. These may include questions such as whether the debt is too high? Whether liquidity is too low? Etc. Helps Identify RiskĮquity valuation, especially when done through the balance sheet method, helps identify the risk areas of the company. Equity valuation helps find undervalued stocks and thereby helps investors pick the right stocks to make an optimum portfolio. The stocks whose fair price is greater than the actual market price are considered undervalued and a good investment. The fair market value may be above or below the actual market value. Dilemma in Selecting a Valuation MethodĮquity valuation, by different methods, calculates the value of the stock, which is considered fair market value.
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