What are Approaches to Valuation of Security?

Security analysis begins with assessing the intrinsic value of the security. There are three main schools of thought on the matter of security price evaluation. Advocates of different schools can be classified as (1) Fundamentalists; (2) Technicians; and (3) efficient market advocates. Let us compare these different perspectives in the summary form before describing them in detail.

(1) The Fundamental Approach: The Fundamental approach suggests that every stock has an intrinsic value. An estimate of the intrinsic worth of a stock is made by considering the earnings potential of the firm which depends upon the investment environment and factors relating to a specific industry, competitiveness, quality of management, operational efficiency, profitability, capital structure, and dividend policy. The earning potential is converted into the present value of the future stream of income from that stock discounted at an appropriate risk-related rate of interest. Security analysis is done to compare the current market value of particular security with the intrinsic or theoretical value. Decisions about buying and selling individual security depend upon the comparison. If the intrinsic value is more than the market value, the fundamentalists recommend buying the security and vice versa.

(2) Technical Approach: The technical analyst endeavors to predict future price levels of stocks by examining one or many series of past data from the market itself. The basic assumption of this approach is that history tends to repeat itself and the price of a stock depends on supply and demand in the marketplace and has little relationship with its intrinsic value. All financial data and market information of a given security is reflected in the market price of a security. Therefore, an attempt is made through charts to identify price movement patterns that predict the future movement of the security. The main tools used by technical analysis are: (1) The Dow Jones theory which asserts that stock prices demonstrate a pattern over four to five years and these patterns are mirrored by indices of stock prices. The theory employs two Dow Jones averages – the industrial average and the transportation average. If the industrial average is rising, then the transport average should also rise. Simultaneous price movement is the main prediction that may show bullish as well as bearish results. Chart Patterns are used along with Dow Jones Theory to predict the market movements.

(3) Efficient Capital Market Theory: The theory is popularly known as “Efficient Capital Market Hypothesis: (ECMH). The advocates of this theory contend that securities markets are perfect, or at least not too imperfect. The theory states that it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. It is based on the assumption that inefficient capital markets prices of traded securities always fully reflect all publicly available information concerning those securities. Market efficiency was developed in 1970 by the economist Eugene Fama, whose theory of efficient market hypothesis stated that it is not possible for an investor to outperform the market because all available information built into all stock prices. For market efficiency, there are three essential conditions; (i) all available information is cost-free to all market participants; (ii) no transaction costs; and (iii) all investors similarly view the implications of available information on current prices and distribution of future prices of each security.

It has been empirically proved that stock prices behave randomly under the above conditions. These conditions have been rendered unrealistic in the light of the actual experience because there is not only transaction cost involved but traders have their own information base. Moreover, information is not costless and all investors do not take similar data and interpretation with them.

Efficient Market Hypothesis has put to challenge by the fundamental and technical analysts to the extent that the random walk model is a valid description of reality and the work of chartists is of no real significance in the stock price analysis. In practice, it has been observed that markets are not fully efficient in the semi-strong or strong sense.

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