9. Stock Analysis: Qualitative Valuation

9. Stock Analysis: Qualitative Valuation

Here, we begin to discuss stock valuation. We start from more qualitative techniques. In the next section, we move onto quantitative valuation techniques. This section includes three qualitative valuation methods: 1) identifying inflection points, 2) looking at market expectations and 3) scenario analysis.

9.1. Improving/Deteriorating Trends and Inflection Points
Stock prices should generally reflect underlying fundamentals at a given company. Many companies seem to show steady and stable growth year-after-year. But, many times, companies will have periods where they are either on an improving trend or on a deteriorating trend. Observing and forecasting these trends and the inflection points at the time of change can be very helpful for qualitative valuation.

A good time to invest in a company may be when the company has seen deteriorating or stable conditions for some time but fundamentals are beginning to show signs of sustainable improvement. If the improvement can be counted on to last for some time, an investor can make money if this improvement has not been reflected in a rising share price. Investor inertia can often set in and, therefore, there are times when fundamentals may be improving for a company but the share price is not. Inflection points are, therefore, opportunities to make returns. Similarly, negative inflection points, when a company that has been showing favorable fundamentals starts to show a deterioration, may signal a good time to exit a position. Sometimes, it pays to invest in a company whose share price has already reflected a positive development to some degree as the trend may be long-lasting and the share price may not have risen enough to reflect the long-lasting nature of the trend. The opposite thing can be said on the downside as well and sometimes it pays to take losses earlier rather than larger losses later.

However, you must be careful when, using this qualitative valuation method, observing or forecasting changes in fundamentals at a given company. Markets are usually forward-looking and oftentimes, the share prices of a given company may move ahead of the change in fundamentals in anticipation. For instance, in a banking crisis or housing bust, you may see banking or housing related shares start to recover although their reported earnings figures are still declining. This can happen if investors anticipate the negative earnings trend will bottom out soon and will reach an inflection point. The shares might also start to decline ahead of the beginnings of a banking crisis or housing bust although reported earnings trends are still favorable as savvy investors anticipate the coming inflection point. This is why accurately gauging market expectations is also a very important aspect of qualitative valuation. This leads us directly to our next topic.

9.2. Market Expectations
One of the most important aspects of valuation are market expectations. One thing regarding the stock market is certain: the current share price of a stock accurately represents the expectations of all the market participants currently buying and selling that stock. If you can accurately gauge where market expectations are for a given share at its current share price, you are halfway to succeeding in being able to accurately gauge the appreciation potential of that share. And if, in addition, you can accurately identify where your opinions of a given company differ markedly from market expectations and if your opinions are correct then you have the means to successfully make investment decisions.

For instance, if company A is making a certain type of widget X and market expectations are that this widget X is likely to be bought by a small segment, say 5%, of the total population whereas you foresee the widget as having characteristics desirable to the entire population, you might be able to make a good return in your investment by investing in company A.

Qualitative valuation based on a divergence in your expectation vs. market expectations is one of the most powerful methods for judging whether a stock is undervalued or overvalued. While this may sound simple to do, in practice it takes a person with strong ability in two areas: 1) judging current market expectations and 2) accurately analyzing the present and future position of the company.

Judging current market expectations is difficult because in most cases there is a wide range of opinions regarding various aspects of a given company. You often see some market pundits with a positive view of a given company while other pundits may have a negative view. With a divergence in opinions, an accurate judgment of what a given stock price is reflecting in terms of market expectations requires an accurate reading on the distribution of positive and negative opinions among the actual buyers and sellers of a given stock. To get an accurate reading on the distribution is difficult as you are generally not able to interview everyone buying and selling a given stock on a given day and, if you were, those market participants might not be interested in giving you their real opinion or any opinion at all. There are, however, some instances when it is easier to read market expectations and that is when market participant’s views appear to converge to a narrow range of similar views. That is when most market participants appear to be either consistently positive or negative across-the-board. While the market participants could be correct in their thinking, if they are wrong, these situations are excellent opportunities for the observant investor.

Having conviction in your view of a company, if it differs from the consensus market view, takes courage and confidence. We believe that an investor’s ability to go against the grain, and be correct, improves with experience and knowledge. We have already outlined the basic tools, in sections 7 and 8 on company analysis, that can help you to formulate your own opinions regarding the prospects for a given company. We encourage you to use these tools to hone your judgment. Spending time thinking about and observing different companies and then tracking those companies over time to see if developments met or did not meet your expectations is a good way of honing your judgment and working on your company analysis skills. Your confidence should build as you work through more and more company analyses.

9.3. Scenario Analysis
The final type of qualitative valuation we will cover here is scenario analysis. Many times investors will tend to think of a stock in terms of a single outcome. In other words, they come up with one way of thinking about the future for a company, and therefore for the company’s stock, and ascribe a high degree of conviction to this outcome. In contrast, we would like to pull you away from this type of valuation model for the moment. Instead, we want to draw your attention to scenario analysis – thinking about multiple outcomes for a company’s stock.

At the most basic level, one can construct two hypothetical outcomes for the stock of a given company – a negative scenario and a positive scenario. We would suggest constructing three scenarios and we will base our current discussion of scenario analysis around three scenarios – a worst-case scenario, a base case scenario and a best-case scenario. These terms should be fairly self-explanatory. If the scenarios are constructed properly, the worst-case scenario should match roughly the downside risk of investing in a given company. The best-case scenario should be close to representing the maximum upside potential for the company in question. The base-case scenario should represent the most likely outcome you see.

Since there is uncertainty involved in every investment, thinking in terms of scenario analysis can help to frame the range of potential outcomes that may result in a given investment. This scenario analysis can also help to sharpen and refine your company analysis, perhaps leading to new insights which otherwise would’ve been hidden. In particular, the scenario analysis exercise will force you to play the part of devil’s advocate. If you are generally positive about a company’s prospects, developing a worst-case scenario should force you to think about what could go wrong.

Each scenario may differ in only one variable or they may differ in multiple variables and assumptions. Factors may be considered in only one of the scenarios and not in any of the others. For instance, a best-case scenario may include the expectation that a company may be acquired at a large premium by another company. This factor might only be part of the best-case scenario analysis but absent from the base-case and worst-case scenarios. Or perhaps, a company may be introducing a new product and the three scenarios may each include revenues from the new product but make different assumptions about the market penetration the new product will achieve. One note of caution is that the worst-case and best-case scenarios should not be made into extreme outcomes for the sake of exaggerating the differences. At the same time, all realistic risks should be included in the worst-case scenario and all realistic upside potential should be encapsulated by the best-case scenario.

Insights gleaned from scenario analysis can then be compared to the scenarios implied in market expectations. This kind of comparison may aid the investor in judging where he or she differs from the market. Additionally, the scenario analysis may be further refined and quantified into worst-case, base-case, and best-case share price targets. This would turn the scenario analysis into a quantitative valuation technique and we will discuss this technique in the next part of our program.

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