Valuation of Equity
Equity valuation is a blanket term and is used to refer to all tools and techniques used by investors to find out the true value of a company’s equity. It is often seen as the most crucial element of a successful investment decision. Investment Banks typically have a equity research department, where research analysts produce equity research reports of select securities in various industries.
Who Uses Equity Valuation?
Every participant in the stock market either implicitly or explicitly makes use of equity valuation while making investment decisions. Everyone from small individual investors to large institutional investors use equity valuations to make investment decisions in equity markets. The total size of the global equity market is estimated to be around $70 trillion and every participant in the stock market, from professional fund managers to academic researchers, is trying to find mispriced stocks.
Inputs in the Equity Valuation Process
The true value of any financial asset is thought to be a good indicator of how that asset will do in the long run. In equity markets, a financial asset with a relatively high intrinsic value is expected to command a high price, and a financial asset with a relatively low intrinsic value is expected to command a low price.
Distortions can take place in the short run, i.e., financial assets with relatively low intrinsic value might command a high price and vice-a-versa, but such distortions are expected to disappear over time. In the long run, the true value of a stock (and thereby the market price of that stock) depends only on the fundamental factors affecting the stock. The factors can be broadly classified into four categories.
- Macroeconomic variables
- Management of the business
- Financial health of the business
- Profits of the business
Individual investors make up the vast majority of stock market investors, aided by the growing wealth of households in the 20th century and a rise in the average education level of households.
In recent times, many developed nations in the world have moved away from a defined benefit approach to retirement funding and towards a defined contribution approach to retirement funding. The move has further increased the number of individual stock market investors.
Under a defined benefit approach to pension management, employers commit to paying their staff a set amount in retirement benefits. In order to meet these needs, employers will invest their employees’ pension funds deposits.
Under a defined contribution approach, employers contribute a certain amount in each period to every employee’s pension account. The employees are then encouraged to invest the money in various financial markets (most commonly government fixed income instruments and equity market indices).
Institutional investors are economic entities that aggregate capital and invest in financial markets on behalf of a set of smaller economic entities. For example, private pension funds aggregate capital from millions of individuals and then invest the aggregated capital in financial markets.
Institutional investors can take advantage of economies of scale and lower administrative fees compared to individual investors. Such investors include hedge funds, pension funds, banks, and governments.