Q: Valuation results generated by your model show drastic under- or overvaluation for some stocks. How confident are you in your valuation methodology?
A: It is all about input parameters to the valuation model. Our valuation algorithm uses historical (i.e. backward-looking) data. Stock valuation, however, is all about the future. We do not pretend to have a crystal ball, and, instead, explicitly assume that the past data is the best predictor of the company's future performance. There are many drawbacks to this approach that, in our opinion, are far outweighed by its major advantage: all stocks are valued on the same objective basis, without interference of any subjective judgement. Having the same 'playing field' for valuation of all stocks allows for fair objective comparisons. Nonetheless, investors are strongly advised to verify all model inputs and adjust them according to their view of the company's future performance.
Q: Your stock valuations are very sensitive to even slight changes to the model input parameters. How do you determine what numeric values of inputs to use?
A: We employ a rather mechanical approach to determining numeric values of inputs. They are determined by a set of calculations performed on historical financial statements of the company in question. All valuation models are very sensitive to input parameters, which should correspond to anticipated future parameters. Future performance, however, does not necessarily has to follow historical data that we use. Therefore, an extreme care should be taken by the investor in selecting values that will best match the company's future performance.
Q: I have been using a DCF calculator on another site that defaults to the discount rate of 11%. I do not understand why your valuation model starts with various discounts rates many of which are below the average return of the market over time. Would you be so kind as to explain this?
A: That's one of a distinguishing features of our valuation model. In calculation of the discount rate we use a calculated probability of the company's default in the period of one year from now (which is usually quite low) and then escalate that discount rate in subsequent years. Site users can change both the initial discount rate and the escalation factor (discount rate multiplier).
Q: Why and how from one week to another a company/stock can go from being substantially undervalued to substantially overvalued?
A: This could happen primarily when new financials become available that change the model's input parameters. We use a computer model for valuation - therefore the input data is so important. Besides the company financials, the valuation is also affected by changes in macroeconomic parameters. In addition to the above, from time to time (quire rarely) we introduce changes to the valuation model itself based on our understanding of the market fundamentals - to make it more theoretically sound.
Q: Why valuation result is not available for some stocks?
A: This primarily has to do with availability and completeness of at least two years of financial data. For some small companies (especially the ones in the 'penny stocks' category) this could be problematic. Another reason: the financial data we have on a particular company is not consistent with the valuation algorithm we use, which puts in question the validity of the valuation result.
Q: The distribution of the ratings for every stock index and sector shows that the majority of stocks is rated as 'sell' even for indices and sectors that are fairly priced or undervalued. How is this possible?
A: The distribution of ratings alone does not show the full picture. Theoretically, on the downside the price of a stock could only go to zero (the loss of 100%), but on the upside it is unlimited. So, a handful of stocks can drive a stock index higher. Therefore, it is OK for the majority of stocks to be rated as 'sell' even in a fairly-priced or undervalued market.
Q: How would you recommend using your valuation model: buying stocks from the 'strong buy' list at the beginning of the year and then selling them at the end of the year or doing a more frequent rebalancing?
A: We recommend establishing long-term positions - for at least a year. Our stock valuations are updated regularly throughout the year and you may act on them whenever you want. It is just for comparison purposes that we track the full-year performance. Of course, there is no guarantee that you will make money following our model's recommendations, but if your portfolio is well diversified the odds are that you will beat the market. You would still need to make your own research on the stocks you select - as our valuation model could be viewed only as a fancy stock screening tool. And one more thing: don't strive for the maximum gain, but rather for the maximum certainty of a gain.
Q: What is the relationship between the intrinsic value of the S&P 500 Index and the S&P 500 validation index?
A: Intrinsic value of an index is our model's estimation where the index should be if it is calculated with intrinsic values of constituent stocks instead of their market prices. The S&P 500 price movement validation index, on the other hand, just confirms (or otherwise) price movement of the index - its absolute value is irrelevant (the base for it was chosen arbitrary). So, these are totally different animals.