Valuation, Intrinsic Value, and Sources of Perceived Mispricing

Valuation 

Valuation is the process of estimating the worth of an asset-based on:

1. Variables related to future investment returns (absolute valuation).
2. Comparison with similar assets (relative valuation).
3. Estimates of the immediate liquidation process. 

Intrinsic Value and Perceived Mispricing 

Intrinsic value is the value of an asset determined by an investor who has a complete understanding of the asset. Investors value an asset because they believe its intrinsic value differs from the market value. This is known as perceived mispricing. This difference presents an opportunity to profit when the market value eventually convergences with the intrinsic value.

Under the efficient market theory, the intrinsic value is assumed to be equal to the market value. Therefore, the need for investors to perform valuation analysis is eliminated as both intrinsic and market values are the same, and any analysis would result in additional costs to the investor. No investor will incur these additional costs of gathering and analyzing data on an asset unless they expect to earn higher returns from the perceived mispricing.

Active investors perform valuation analysis to earn higher returns than returns proportional to the asset’s risk. An active investor aims to earn a positive risk-adjusted return. This return is known as abnormal return or alpha. 

Sources of Perceived Mispricing

There are two possible sources of mispricing:

1. True mispricing (market error): This is the difference between the market price and the actual intrinsic value of the asset.
2. Valuation error (analyst error): This is the difference between the actual intrinsic value and the estimated intrinsic value.

$$\begin{align} \text{Perceived Mispricing}&=\text{True Mispricing}+\text{Valuation Error} \\ \text{V}_{\text{E}}-\text{P}&=(\text{V}-\text{P})+(\text{V}_{\text{E}}-\text{V}) \end{align}$$

Where:

\(\text{V}_{\text{E}}=\) Estimated Value.

\(P =\) Market Price.

\(V =\) True Intrinsic Value.

Even without an error in the estimation of the intrinsic value, an investor may not realize the benefits of conducting the valuation analysis as the market value may not converge to the intrinsic value within the investor’s investment horizon.

Question

The value of an asset, given a hypothetically complete understanding of its investment characteristics, is most likely the:

1. Fair market value.
2. Intrinsic value.
3. Investment value. 

Solution

The correct answer is B.

The intrinsic value is the value of the asset based on a hypothetically complete understanding of the asset’s investment characteristics. In other words, it is the perceived actual value of an asset rather than its market price or book value. 

A is incorrect. The fair market price is the price at which an asset or liability changes hands between a willing buyer and a willing seller when neither party is under compulsion to buy or sell.

C is incorrect. The investment value is the concept of value to a specific buyer considering potential synergies and based on the investor’s requirements and expectations.

Reading 22: Equity Valuation: Applications and Processes

LOS 22 (a) Define valuation and intrinsic value and explain sources of perceived mispricing.