The Hindu Business Line : Factoring human emotions into stock valuation

Stock prices often move beyond the target prices that are calculated through models based on cash flows. What causes this and how can you factor inconsistent choices that investors make into stock valuation?

B. Venkatesh

Asset prices are footprints of human behaviour. If you and I buy Reliance Natural Resources, it is because we perceive the stock to hold value at the current levels. When we execute the transaction, our perceptions are embedded in the asset price, as are the perceptions of all traders and investors in the marketplace.

Equity research reports do not price these emotions into the valuation model. The upshot is that asset prices wander far above the estimated target prices mentioned in research reports. This article attempts to advance a dialogue on how to price human behaviour into the valuation models.

The problem

A sell-side report on Reliance Petroleum issued in early September placed a price objective of Rs 140 on the stock when it was trading at Rs 110-115. Two months later, the stock touched a high of Rs 295 and continues to trade well above the estimated intrinsic value.

A research report issued in mid-October recommended a sell on Educomp Solutions when the stock was trading at Rs 2900-3000. The stock currently trades at Rs 4,300. Is the market mispricing stocks? Or is the research process not considering all variables?

The equity research process is rigorous. Analysts talk to the management, prepare their own estimates and also compare them with the consensus estimates.

Typical building blocks for a valuation model are cash flows, growth rates and cost of equity. All these factors are primarily based on the company’s fundamentals. Take the Price-earnings Multiple. Analysts discount future earnings and then apply a forward price-earnings multiple on the forecast EPS to arrive at the estimated price for a stock.

Analysts typically assume that asset prices eventually revert to their mean. That is, even if asset prices move away from their estimated intrinsic value, they will eventually revert to this value over time. This may be true. The problem, however, is that we cannot provide a time-horizon within which the assets will revert to their actual value. So what is the next course of action when a stock moves beyond the price objective?

Often, analysts are apprehensive about revising their target price. What if they revise upward the price objective and then the stock price declines sharply? To have a stock overshoot the initial price objective is one thing. To watch the stock decline below the revised estimated value is quite another!

Behavioural Model

There is, hence, a need to price assets in tune with market conditions, which are merely a reflection of collective human behaviour. Experts in behavioural finance and neurofinance show how our emotions drive our trading behaviour, which in turn drives asset (stock) prices.

Our behaviour typically follows a pattern. If we are offered Rs 10,000 today or Rs 10,500 next year, we will prefer the former. But if we are offered Rs 10,000 after seven years or Rs 10,500 in eight years, we may prefer the latter. Economists have long studied the relative values we assign to payoffs at different points in time. They call it ‘Inter-temporal Choice.’

What if we extend this concept to asset pricing? It would mean that lower risk may be assigned to cash flows today as compared with those in the near future. But the risk factor comes down as we move farther into the future.

This goes against our basic understanding that risk increases with time. Psychologists have shown that we do not in reality price risk that way. Can we then apply differ rates of discount, rather than a single one, to calculate the present value of future cash flows?

Economists use ‘hyperbolic discounting’ to capture such choices over time. But such a calculation will be complex, as our behaviour is not consistent over time.

Today, an investor may perceive Rs 10,500 received in 2008 as risky compared with Rs 10,000 received immediately. But in 2008, money received immediately will be preferred to that expected in 2009. The same investor may choose to receive Rs 10,500 in 2017 (eight years hence) over Rs 10,000 in 2016. That is, we prefer today’s cash flows over the near-term cash flows. Yet, when cash flows are a few years away, we are willing to assign lower risk to the later cash flows.

Analysts cannot issue a revised report each year just to change the discount rate (cost of equity) and revise their price objective. Perhaps, a practical approach would be to significantly lower the cost of equity when a stock’s terminal value(the residual value at the end of the holding period) is calculated. Such an approach will be consistent with our risk behaviour and also increase the estimated intrinsic value; for terminal value usually makes up a substantial proportion of the intrinsic value for a stock. .

Caveat: This article is food for thought. Research in this area is nascent. Over time, this column will develop several methodologies to price human behaviour into asset and stock valuation.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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