Investors hoping to maximize their gains try to identify stocks that are mispriced, creating long opportunities for underpriced companies and short opportunities for overpriced shares. Not everyone believes a stock can be mispriced, particularly those who are proponents of the efficient markets hypothesis. Efficient markets theory assumes that market prices reflect all available information regarding a stock and this information is uniform. Such observers also contend that asset bubbles are driven by rapidly changing information and expectations rather than irrational or overly speculative behavior.
Many investors believe markets are mostly efficient and some stocks are mispriced at various times. In some cases, the entire market can be pushed beyond reason in a bull or bear run, challenging investors to recognize the peaks and troughs in an economic cycle. Information on a company might be overlooked by the market. Small-cap stocks are especially prone to irregular information because there are fewer investors, analysts and media sources following these stories. In other cases, market participants may miscalculate the magnitude of news and temporarily distort a stock’s price.
These opportunities can be identified through several broad methodologies. Relative valuation and intrinsic valuation both focus on a company’s financial data and fundamentals. Relative valuation employs a number of comparative metrics that allow investors to evaluate a stock in relation to other stocks. Intrinsic valuation methods allow investors to calculate the value of an underlying business independent of other companies and market pricing. Technical analysis allows investors to identify mispriced stocks by helping them to identify likely future price movements caused by the behavior of market participants.
Financial analysts employ several metrics used to relate price-to-fundamental financial data. The price-to-earnings ratio (P/E ratio) measures the price of a stock relative to annual earnings per share (EPS) generated by a company, and it is usually the most popular valuation ratio because earnings are essential to determining the actual value the underlying business provides for earnings. The P/E ratio often uses forward earnings estimates in its calculation because prior earnings are theoretically already represented in the balance sheet. The price-to-book (P/B) ratio is used to show how much a company’s valuation is generated by its book value. P/B is important in the analysis of financial firms, and it is also useful for identifying the level of speculation present in a stock’s valuation. 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 spending requirements. The EV/EBITDA ratio can help when evaluating firms that operate in different industries.
Yield analysis is commonly employed to express investor returns as a percentage of the price paid for a stock, allowing the investor to conceptualize pricing as a cash outlay with potential for returns. Dividends, earnings and free cash flow are popular types of investment returns and can be divided by the stock price to calculate yield.
Ratios and yields are insufficient to determine mispricing by themselves. These numbers are applied to relative valuation, meaning investors must compare the various metrics among a group of investment candidates. Different types of companies are valued in different ways, so it is important for investors to use sound comparisons. For example, growth companies typically have higher P/E ratios than mature companies. Mature companies have more modest medium-term outlooks and also typically have more debt-heavy capital structures. The average P/B ratio also varies substantially among industries. While relative valuation can help determine which stocks are more attractive than their peers, this analysis should be limited to comparable firms.
Some investors ascribe to the theories of Columbia Business School’s Benjamin Graham and David Dodd, who contend that stocks have an intrinsic value independent of the market price. According to this school of thought, the true value of a stock is determined by fundamental financial data and usually relies on minimal or zero speculation regarding future performance. In the long-term, value investors expect the market price to tend toward intrinsic value, though market forces can drive prices temporarily above or below that level. Warren Buffett is perhaps the most famous contemporary value investor; he has implemented the Graham-Dodd theories successfully for decades.
Intrinsic value is calculated using financial data and may incorporate some assumptions about future returns. Discounted cash flow (DCF) is one of the most popular intrinsic valuation methods. DCF assumes a business is worth the cash it can produce, and that future cash must be discounted to present value to reflect the cost of capital. Though advanced analysis requires a more nuanced approach, balance sheet items at any given point in the life of a going concern merely represent the structure of the cash-producing business, so the entire value of the company can actually be determined by the discounted value of expected future cash flows.
Residual income valuation is another popular method for calculating intrinsic value. Over the long term, the intrinsic value calculation is identical to discounted cash flow, but the theoretical conceptualization is somewhat different. The residual earnings method assumes a business is worth its current net equity plus the sum of future earnings in excess of required return on equity. The required return on equity is dependent on a number of factors and can vary from investor to investor, though economists have been able to calculate implied required rate of return based on market prices and debt security yields.
Some investors forgo analyzing the specifics of a stock’s underlying business, opting instead to determine value by analyzing the behaviors of market participants. This method is called technical analysis, and many technical investors assume market pricing already reflects all available information regarding a stock’s fundamentals. Technical analysts forecast future stock price movements by forecasting future decisions of buyers and sellers.
By observing price charts and trading volume, technical analysts can roughly determine the number of market participants willing to buy or sell a stock at various price levels. Without major changes to fundamentals, the entry or exit price targets for participants should be relatively constant, so technical analysts can spot situations in which supply and demand imbalances at the current price exist. If the number of sellers at a given price is lower than the number of buyers, then it should drive prices upward.