Qualitative vs Quantitative Techniques in Stock Valuation 3 comments

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Classic stock valuation is highly quantitative. Those who are academically inclined in this field would be familiar with discounted cash flow stock valuation, capital asset pricing model and other quantitative models.

These quantitative techniques can be very daunting to the starting small investor who has no idea, for example, what discount factors to use or where to get industry betas. Clearly quantitative models can only be used with acceptable accuracy by stock professionals who have required parameters at their fingertips. So what recourse do small investors have if they desire to get a perspective on whether a stock might be currently overvalued or undervalued?

My view is that qualitative analysis alone is often an adequately robust method to determine whether a stock is more likely to move further up or down. I take the position that the market is typically efficient in pricing in breaking news (even before it is announced publicly) but adjusts more gradually to the intrinsic fundamentals of the company and its industry sector. It is logical why the market should adjust gradually to intrinsic fundamentals rather than in one leap. Earnings momentum, industry momentum and investor psychological momentum feedback to each other during the rise of a medium to long-term fundamental trend; as each improved earnings report confirms that the industry's prospects are getting better, investors will grow more optimistic and value the stocks at higher multiples. All this takes time and it thus makes sense then for the small investor to focus his efforts on understanding the company and its industry sector holistically, in particular its general prospects and industry dynamics, such that one can "catch the move early". In short, price movements are random if one chooses to see them as such, but NOT random if one sees them as composing a random component and a systematic component; the random component being price adjustments to breaking news (broker upgrades/downgrades, favourable/unfavourable daily newspaper reports and other very short-term factors), the systematic component being a medium to long-term upward/downward trend reflective of the company/industry fundamentals.

What I mean by qualitative analysis means that one focuses on understanding business dynamics and intangible factors like management transparency and capability, technology and R&D capability etc. The trend of revenue growth and profit margins, and whether supply and demand are more likely to trend upwards or downwards, are such qualitative business dynamics issues. In reading accounting statements, focusing on key issues such as topline and bottomline growth trend, profit margins, earnings quality, management outlook, important segmental growth drivers and generally understanding and appreciating the company's operations is better than diversifying one's efforts in delving through all the numbers and seeking to estimate next year's or next next year's revenue and profits, going through the whole discounted cash stock valuation process etc; that process should be left to the brokerages.

As for actual numbers, I usually only refer to a few. The key valuation metrics which are usually available everywhere -- the PE, the P/NTA, return on equity. It is usually gives one more perspective to compare these numbers to historical averages as well as industry averages rather than looking at them in absolute. As for market alphas, betas, theoretical valuations, free cash flow, discount factors, sheesh... who has time for all that?