Intrinsic Value and Mispricing

The whole objective of equity valuation is to find mispriced securities. Investors can make abnormal profits when they find securities which are lower than their intrinsic worth trading in the market. However, the concept of mispricing and intrinsic value is misunderstood to say the least. What the average person considers as mispricing is at best a narrower concept, an estimation of what mispricing truly is. In this article, we will explore in detail the concept of mispricing.

Two Layers vs. Three Layers

The average person considered mispricing to be a two layered concept. This means that they believe that there is a given market price and then there is the intrinsic worth of the security i.e. the two layers. They believe that the true intrinsic worth of the security can be calculated with precision and mispriced securities can be discovered.

However, this is not the truth. Since the whole subject of valuation is an imperfect science, the true intrinsic worth of a security can never be found out for sure. At best, we can get approximations. Human error will always be present. A better analyst may provide a more accurate estimate of the intrinsic worth of the security. However, it will still be an estimate and not the intrinsic worth itself.

Hence, finding mispriced securities is about understanding the three layers i.e. the quoted market price, the estimate of intrinsic value and the intrinsic value itself. Hence, there will actually be two gaps which need to be taken into consideration before making an investment decision.

The Two Gaps:

Since there are three layers present and the difference between any two layers forms a gap, there will be two gaps present. The details regarding these gaps are as follows:

  • Gap #1: Market Mispricing:This is the mispricing that arises because of temporary euphoria and pessimism in the marketplace. Investors start believing that the present boom or doom is permanent and stocks either rise or fall to unrealistic levels. Since this a gap between the quoted market price and the analyst’s estimate of intrinsic value, it is called market mispricing. This is a known risk and hence can be controlled. It is driven by the sentiment in the market.
  • Gap #2: Analyst Mispricing:On the other hand, analyst mispricing represents the risk that the analyst’s estimate of intrinsic value may itself vary significantly from actual intrinsic value of the firm. Since the actual intrinsic value is not known, this is an unknown risk. Every analyst makes the best effort to arrive at the correct valuation. However, because there are so many factors involved it is likely that the estimated intrinsic value may be significantly higher or lower than the actual value. This is an unknown risk and hence more difficult to mitigate.

Mitigating the Two Gaps:

Now, since we are aware that there are actually two types of gaps present, we must understand how professional investors mitigate the risks arising from these gaps. The usual mitigation plans are as follows:

  • Multiple Models:Firstly, an attempt is made to arrive at the best possible estimate of intrinsic value. For this purpose, instead of using a single model, analysts often use multiple models. The valuations derived from these models may vary significantly from one another. However, the difference in valuations leaves clues to what the drivers of higher valuation as per a given model are.
  • Multiple Analysts:Secondly, to reduce the risk of person driven errors and to make the valuation exercise more process driven, companies often use multiple analysts. Different analysts think differently and provide their version of what the future prospects for the target company are expected to be. These multiple opinions help in reducing the unknown risk. The risk of analyst mispricing is always present but, to some extent, this exercise reduces its effect.

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Equity Valuation