Two Dangerous Myths about Valuations

The topic of valuation is widely discussed but somewhat unfortunately, many misplaced beliefs about it have been developed over the years of discourse between market participants.

Here are two myths in particular about valuation that can be dangerous for investors.

Myth 1: The valuation process is objective

When you value an asset or a company’s shares, math would inevitably be involved. As such, many assume that the value that’s arrived at after all that calculation has to be objective and more importantly, correct.

Thing is, although the use of math can allow investors to arrive at precise values, there are many assumptions that need to be considered by the investor before he or she can come up with the final figure. As such, two investors looking at the same company at the same time with the same information can come up with a final valuation figure that differs greatly from each other.

We can observe this situation in real life just by looking at local brokerage reports with Singapore’s largest publicly-listed land transport outfit SMRT Corporation (SGX: S53) providing a great example in this instance. The company is covered by both Maybank Kim Eng and OCBC Securities and earlier this year, the brokerage firms had issued a target price of S$0.60 and S$1.30 respectively for SMRT.

How is it possible that the analysts from the brokerage firms could look at SMRT, a business with a rather straight forward business model, and come up with a calculated share value that’s so far apart? That’s because the analysts, who are only human, might have fallen prey to biased assumptions. As humans, we have a tendency to form an opinion about something (the company) before we even look at the relevant information in detail. This then translates into a bias when we make assumptions about the future of the business, which of course, would have a big effect on the calculated value of a company’s shares.

All told, this shows how the art of valuation is a subjective process and that investors should pay particular attention to the assumptions that are made in any valuation work done.

Myth 2: A good valuation report is everlasting

Many investors tend to judge the quality of a report by its accuracy in predicting the price of a company’s shares in the future. Therefore, if one analyst has been consistently right in predicting the movement of the share price of a company, many might hold his or reports in very high regard.

This can create a problem whereby investors hold on to the analyst’s view of a company regardless of how much time has passed since the initial publication of the report. In an age when information is being distributed almost instantly, a thoughtful and well-written report might be very valuable and relevant when it was first written. But if the report was done say, five years ago, its relevance might have been greatly diminished as the value of a company’s shares can change dramatically based on new developments and information as time passes.

A good example of such a scenario could be found with Resorts World Sentosa operator Genting Singapore (SGX: G13) before and after it had won the bid to construct an integrated resort in the island of Sentosa; after the bid was won, the prospects for Genting Singapore were totally transformed and it’s likely that the value of the company would have changed dramatically as well.

Foolish Summary

Although there are no perfect valuation tools that can help us find the right value of an asset, they still serve a very important function in helping us estimate the value of an asset. As long as we know the limitations inherent within the valuation process, we will still be able to use our number-crunching to make informed decisions about any investment opportunity.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.