Assumptions Made During Stock Price Valuation
Estimating the value of equity stock of a company is not an easy proposition. This is because while estimating the stock price, all the data required to be used in the formula is not easily available. This is because the data is subjective.
It is really the analysts call on what they believe about the company, its future and based on it what numbers they input in the formula.
Also, slightly different numbers used in the formula give vastly different results. Hence, an analyst must have a strong basis to use any number as an input to the stock valuation formula.
Here are some of the common assumptions that will have to be made by the analyst during the stock valuation exercise:
As we learned in the previous article that stock valuation happens in two stages. The first stage is the horizon period for which exact cash flows are estimated.
Beyond the horizon period, the stock is considered to be a growing perpetuity and its value is estimated. But the question is How big or small should the horizon period be and why? We need to understand that the answer to this is not factual or based in proof.
Rather, the answer is based on subjectivity and convention. It is therefore entirely up to the analyst to decide what the horizon period should be?
An investor, however must be aware that changing the horizon period has massive effects on the stock valuation and must therefore watch out for the same.
Constant Growth Rate
After the horizon period is over, the stock is considered to be a growing perpetuity. This means that it will continue growing at a constant rate for the rest of its perpetual life.
This rate must be less than the required rate of return or else the answer we will receive will be infinite since it will no longer be a decreasing infinite series.
But, then what should that constant rate of growth be? This is again a matter of great subjectivity. Once again the analyst has a high level of discretion in this decision.
Also, this assumption is extremely important because the value of the perpetuity accounts for almost two thirds of the stock price in most cases.
A wrong assumption here can therefore give a significantly higher or lower stock price.
Cost of Capital
Apart from the expected returns to be realized from the venture, there is also a great deal of subjectivity regarding the riskiness that is involved in each case. It is obviously difficult to compare the riskiness across industries and across companies.
It is for this reason that estimating the cost of capital becomes relatively difficult. The market is efficient in pricing risk to a large extent.
The cost of equity capital is calculated using data from the market from the past few years. But once again, the riskiness can be very different depending on whether we select data for the past 10 years or for the past 15 years. This makes it a subjective decision too!
Future Growth Opportunities
Also, the cash flows in the horizon period are estimated based on what the analyst thinks the future looks like in the next 5 to 7 years or whatever is the chosen horizon period. But, it is important to know that these estimates rarely end up being accurate.
Consider the fact that business cycles are largely unpredictable, and so are the moves by the competition and we understand why we cant be relatively certain even about the future in the short and medium term.
The bottom line therefore is that any stock valuation is like a building which is standing on the pillars of its assumptions.
A good investor will therefore first investigate the soundness and reasonableness of its assumptions before deciding whether or not the stock valuation is fair.
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- Discounted Cash Flow Approach
- What is Cost of Equity ?
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