Aswath Damodaran (known as the Dean of Valuation) is a Professor of Finance at the Stern School of Business at New York University. In his book Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, University Edition he describes 6 types of investors and how they use valuation to help them make investment decisions.
1. Fundamental Analysts
Fundamental analysts believe the value of a firm is related to its financial characteristics such as growth, risk and cash flows. If the price differs from this value then the stock is either under or over-valued.
Fundamental analysts assume:
- We can measure the relationship between a company’s value and its financial fundamentals.
- The relationship between value and fundamentals is stable over time.
- Any deviation between price and value is corrected in a reasonable amount of time.
Fundamental analysts will use discounted cash flow or multiples such as price-earnings or price-book to value companies.
Investors using this approach will buy a large number of undervalued stocks in their portfolio in hope that on average this portfolio will do better than the market.
2. Franchise Buyers
Franchise buyers concentrate on a few businesses which they know well.
The assumptions of franchise buyers are:
- An investor who understands a business well is in a better position to value it correctly.
- Undervalued businesses can be acquired without driving the price above true value.
Chartists believe psychology moves prices just as much as a company’s fundamentals. They believe future price movement can be predicted based on past price movements, trading volume, chart patterns etc.
- Prices move in predictable patterns.
- There are not enough investors taking advantage of these patterns to eliminate them.
- The average investor is driven by emotion.
4. Information Traders
Prices move when new information enters the market. Information traders attempt to trade in advance or shortly after new information is released.
Information traders assume:
- They can anticipate information and gauge the market’s reaction better than the average investor
Information traders are more interested in how information affects value rather than the underlying value itself. That means an information trader will buy an overvalued stock if they think new information will drive the price up.
5. Market Timers
Market timers believe there are greater returns to be made by predicting the turns of the market rather than picking individual stocks. They believe there are factors that can be observed which make predicting market movements easier than selecting stocks.
6. Efficient Marketers
Efficient marketers believe that the current price of a stock is the best estimate of its value. They believe that the market collects and interprets information so quickly that stocks can never be over or undervalued. Efficient marketers will value a stock to determine the assumptions used to price it. That is its assumed growth rate and required rate of return.
What type of investor are you?
If you enjoyed this post check you Damodaran’s book Investment Valuation: Tools and Techniques for Determining the Value of any Asset