11 Rules for Equity Valuation
Dan Pickett
/ Categories: Company Analysis

11 Rules for Equity Valuation

Enterprising Investor post

Valentine's 11 Rules (with comments):

Rule 1 – Avoid Complexity. Valentine references an apt quote from Albert Einstein: “Everything should be made as simple as possible, but not simpler.” I couldn’t agree more.

Rule 2 - Derive an Accurate Forecast before Starting Valuation. Valentine notes accurate forecasts are the product of skills and tools, with tools meaning spreadsheets or valuation models. While you need to be proficient with the tools, the skill is understanding what will drive the stock in the unknown future. I agree – that is how an analyst adds value.

Rule 3 - Focus on One to Four Critical Factors per Stock. We call these key drivers in the CMC training sessions. Same concept. Focusing on the limited number of important things that will drive the stock puts you in a position to diligence those drivers and develop an informed opinion (forecast) of how they will evolve and affect the stock price in the future.

Rule 4 – Don’t Seek Out-of-Consensus Ideas from Company Management. Valentine believes the best analysts find unique information sources. In AEMR ‘s field research module, Ricky emphasizes field work is NOT about talking to the company or Wall Street analysts, but about identifying other sources that can provide insights that help you understand the company better and develop a view. Same point stated differently.

Rule 5 – Start with the Consensus Valuation. Valentine is focusing on the valuation model here and says, “Often the consensus method is the right one.” As importantly, I would say the market is usually discounting the consensus view, so starting with consensus can help you better understand the valuation framework the market is using and makes it easier to assess the incremental value associated with any non-consensus view you express.

Rule 6 – Stress Test with Scenarios. For me there are two related ideas. First I spend as much time researching the alternative scenario as my own. Really understanding the opposite view helps me build conviction in my own. Second, I want to know the downside if I’m wrong.

Rule 7 - Identify Uniqueness of Forecast and Valuation. Here Valentine focuses on identifying your divergent view and only changing a price target for a reason. The second point seems obvious, but the first is critical. If you don’t have a non-consensus view, there is no reason to believe a stock is mis-priced.

Rule 8 – Know “What’s in the Stock.Yes - having a good estimate of market (consensus) expectations is necessary for you to assert that you have a non-consensus view.

Rule 9 - Minimize Mind Traps. Here the emphasis is on handling stress, but could just as easily reference understanding typical behavioral biases and seeking to avoid them.

Rule 10 - Use a Dynamic and Comprehensive Comp Table. This is more relevant to sell-side analysts that the typical buy-side analyst. An alternative might be, make sure the comps you use really are good comps – control for differences in growth, returns, and risk – the key drivers of valuation we discuss in CMC and AEMR.

Rule 11 – Cover Fewer Stocks and Sectors. The point, I think, is to not try to do too much or you’ll end up not doing anything well. Fair point.

Keep It Simple: 11 Rules for Equity Valuations by Paul McCaffrey

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