Equity Valuation

Definition

In finance, valuation is a process of determining the fair market value of an asset. Equity valuation 

therefore refers to the process of determining the fair market value of equity securities.

Throughout finance, one rule always holds true. The general belief is that the value of any asset or security

is exactly equal to the discounted present value of all the cash flows that can be derived from it in future 

periods.

Using this principle, one can easily value securities like debt. This is because they have a finite existence.

 The cash flows derived from them can be easily predicted. However equity valuation is not so simple.

 Equity represents a partnership in the business. As such, it represents an attempt to value cash flows which are uncertain and unpredictable.

Investors, stand to gain a lot of money if they are able to correctly identify this difference. The second 

richest person in the world, Warren Buffett has made his fortune correcting and applying the art of equity

 valuation. In fact, the theory of equity valuation has been heavily influenced by the work of Warren Buffett 

and his mentor.

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.

1.     Macroeconomic variables

2.     Management of the business

3.     Financial health of the business

4.     Profits of the business

Individual Investors

Individual investors make up the vast majority of stock market investors, aided by the growing wealth of households in the 20^th 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

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.

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