Naturally this is also a question of great practical interest to investors. If someone has the chance to buy 100 shares of the Acme Widget Company for £1 each it is not immediately clear whether or not it is a good deal. But if there is some indication of the value of the shares - whether they are really worth 50p or £2 - the decision becomes easier.
Some free market economists try to sidestep the problem by arguing that, at least in developed markets, shares are by definition worth what investors are prepared to pay. But even if this is true it still leaves open the question of working out whether shares are likely to rise or fall in the future.
What is true of shares also applies to markets. It is useful for investors to be able to measure whether a particular market is undervalued or overvalued relative both to historical levels and compared to other markets.
Financial economists have over the years devised numerous measures to try to resolve these problems. While each of them has advantages and disadvantages it is important to consider the key measures when investing in shares.
“All of these things are useful at certain points in time,” says Mike Lenhoff, the chief portfolio strategist at Gerrard. “They have to be used not on their own but with a number of tools”.
Uncertain markets
It is important to recognise that there is no perfect model of valuation. Markets by their nature involve a degree of uncertainty so it is not possible to predict exactly where share prices will move. Indeed one of the main reasons to have a stockmarket is to provide a mechanism to resolve differences of opinion about the value of shares.
It is not possible to do justice to the intricacies of this topic in a relatively short article. There is a vast debate on the rights and wrongs of the numerous available methods of valuation. But it is useful for fund investors to at least be familiar with some of the key elements of the discussion.
The most basic valuation approach – and the basis for many more complicated methods – is the dividend discount model (DDM). This is based on the idea that shares can essentially be seen as claims on future flows of income.
The easiest way to understand this method is to take a simple example. Suppose that each share of Acme Widget pays a dividend of £1 in its first year. The income then rises by 10% every year. So it will be £1.10 (£1 + 10%) in the second year, £1.21 in the third and so on.
Under the DDM the price of the share should reflect the present value of these future dividends. To work out the present value of these flows it is necessary to project back – or “discount” – these income flows.
Reverse interest
Discounting is essentially the reverse process of working out the impact of an interest rate. So most people can easily see that someone who has £1 in a bank account which pays 5% a year will have £1.05 at the end of first year. Another way of expressing the same thing is that the present value of £1.05 in a year’s time is £1 today.
The DDM values shares by estimating all the future dividend flows then discounting them back to work out their present value. So with some relatively simply mathematics it is easy to work out if a share is fairly valued. Investors can then decide whether the current price of a share represents a bargain or not.
Naturally in the real world the DDM is not as simple to apply as it seems in theory. For instance, it is not easy to devise accurate estimates of future income flows, particularly those that are far into the future. There is also room for debate about the appropriate discount rate to use.
While the DDM can be a useful indicator of the fair value for individual shares it is not suited to funds. In a portfolio of 100 or even just 40 shares there are probably too many variables to make the DDM meaningful.
Morningstar ratios
There are three key valuation ratios for funds on the Morningstar site. Strictly speaking these do not apply to the funds themselves but to the average of the shares within a particular portfolio.
· Price-earnings ratio (p/e). The price of a share divided by the earnings per share. This is probably the most common measure of valuation. Its main advantage is that it is so widely used and recognised. Disadvantages include the fact that profits can be incorrectly measured and there is no “normal” level for this ratio.
· Price-to-book (p/b). The price of a share divided by its book value. The book value refers to the net asset value of a company’s securities.
· Price-to-cash flow (p/c). The market capitalisation of a firm divided by the net cash provided by operating activities.
It would be wrong simply to look at these measures in the abstract. Each of these ratios must be considered in relation to the specific characteristics of a portfolio and the market in which it invests.
For example, valuation levels tend to be higher when inflation and interest rates are low. Such variations can account for differences between markets or the same market at different times.
Intangible assets
There is also a heated debate about how to valuate the intangible assets of a company. So while it is relatively easy to value a firm’s physical assets it is much harder to put a monetary value on such things as its brand or the skill of its employees. Indeed accountants are spending a lot of time trying to work out sophisticated valuation measures which can take into account such intangibles.
This debate became particularly heated in the run-up to the peak of Nasdaq, the technology-heavy US stockmarket, in March 2000. Many technology firms relied much more heavily on the knowledge of their employees rather than their physical capital. Often they had a promise of earnings in the future rather than current profits which could be used to value the company.
From this perspective the Nasdaq market correction can be seen as a re-evaluation of the true value of such firms. Investors decided that the intangibles and promises of future profits were not worth as much as they had previously thought.
One of the most interesting debates on valuation in recent years is about the “Q ratio”. Its advocates argue that this measure, devised by one of the leading financial economists in the US, it provides a superior method of measuring the value of markets and shares [See Andrew Smithers and Stephen Wright, Valuing Wall Street: Protecting Wealth in Turbulent Times, New York: McGraw-Hill].
In market terms the definition of q is the value of the stockmarket divided by corporate net worth. The term “corporate net worth” refers to the cost of replacing the assets of all quoted companies. So when q is high in historical terms it means it is overvalued.
For individual companies the definition of q is the share price divided by the corporate net worth per share. If q is too high it is also usually followed by a fall in the share price.
Perverse results
Proponents of q argue that traditional valuation measures can lead to perverse results. For instance, the p/e ratio of the US market in 1932 was high despite the market plummeting after the Wall Street crash. Although share prices had plummeted the profits of companies had fallen even further. So investors who used this measure would have missed a spectacular buying opportunity.
For advocates of q the stockmarkets in the US and the UK are grossly overvalued at present. Their case is that share prices have always fallen, at least sooner or later, when q is too high.
The defenders of traditional valuation models counter the q advocates in several ways. For instance, the argue that q does not take sufficient account of intangible assets.
This debate underlines the imperfect character of all valuation measures. All investors can do is monitor some of the key measures and also rely on their instincts about which way shares or markets are likely to move.
