Damodaran on Valuation

1.4. ROLE OF VALUATION

Valuation is useful in a wide range of tasks. The role it plays, however, is different in different arenas. The following section lays out the relevance of valuation in portfolio management, in acquisition analysis, in corporate finance, and for legal and tax purposes.

1.4.1. Valuation in Portfolio Management

The role that valuation plays in portfolio management is determined in large part by the investment philosophy of the investor. Valuation plays a minimal role in portfolio management for a passive investor, whereas it plays a larger role for an active investor. Even among active investors, the nature and the role of valuation is different for different types of active investment. Market timers use valuation much less than investors who pick stocks, and the focus is on market valuation rather than on firm-specific valuation. Among stock pickers, valuation plays a central role in portfolio management for fundamental analysts, and a peripheral role for technical analysts.

The following subsections describe, in broad terms, different investment philosophies and the roles played by valuation in each one.

1.4.1.1. Fundamental Analysts

The underlying theme in fundamental analysis is that the true value of the firm can be related to its financial characteristics—its growth prospects, risk profile, and cash flows. Any deviation from this true value is a sign that a stock is undervalued or overvalued. It is a long-term investment strategy, and the assumptions ...