In this article, let's take a look at the process of determining the value of an asset, refer as valuation. There are several approaches (absolute valuation models, relative valuation models and the method of comparables), and the analyst´s ability is crucial in this process. If the analyst has a complete understanding of the characteristic of the asset, what he is determining is the intrinsic value of the asset.
If the efficient market theory exists, then the best estimation of the intrinsic value of a security is its price. But we all know that stock prices are not perfectly (informationally) efficient, so the trading price diverges from the intrinsic value; this is called mispricing. And here the ability of the analyst to produce positive risk-adjusted return, sometimes called abnormal return or alpha, is crucial.
That mispricing can be divided in two sources: the difference between the market price and the intrinsic value (actual or true mispricing) and the difference between the estimated intrinsic value and the actual intrinsic value (valuation error).
To put it simple in an equation, VE – P = (V - P) + (VE - V)
Where:
VE = estimated intrinsic value
V = actual intrinsic value
P = market price
Now let´s introduce some couple of concepts. A required rate of return, sometimes called the opportunity cost, is a minimum level an investor requires given the asset´s risks. It is an expected return, because it is based on futures prices and forecasts. In that way, more risky assets should have a higher required return.
But what happens when the expected return is not equal to the required return? It is simple. A return from convergence of price to intrinsic value appears. In mathematical terms:
Expected Return = Required Return + (V0 – P)/ V0
Where: (V0 – P)/ V0 is the “convergence yield”.
But reformulating the equation we obtain:
(V0 – P)/ V0 = Expected Return - Required Return = Expected Alpha
To illustrate the concept, let´s consider the analysis of a previous article, where we discuss the valuation of The Home Depot, Inc. (HD, Financial). We estimate that the required return for the company was 18.5%. At that time, the market price was $116.07 and our estimated intrinsic value was $282.53. Thus, The Home Depot was undervalued by: $282.53 - $116.07 = $166.46 or 143.41% as a fraction of market price. So now, if the analyst thinks that the price will converge to its intrinsic value in one year, an investor would expect to earn: 18.5% + 143.41% = 161.91%.
Of course, there exist inefficiencies that impede this price convergence that we are talking about. Nonetheless, several hedge fund gurus bet on this stock. Louis Moore Bacon (Trades, Portfolio) bought the stock, while Stanley Druckenmiller (Trades, Portfolio), Steven Cohen (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and the funds Pioneer Investments (Trades, Portfolio) and Manning & Napier Advisors, Inc. have added the stock in the last quarter of 2014.
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks
