Equity Markets, Valuation, and Analysis

CHAPTER 12Market-based Valuation

Sang Hoon Lee

Professor of Finance, BRAC University

INTRODUCTION

Financial asset valuation is generally based on the principle of substitution under an “arbitrage-free” condition. The broad premise for this principle is an efficient market for economic transactions. This condition implies that two identical assets or perfect substitutes should be priced equally, assuming no market frictions such as transaction costs.

An asset's price may deviate from its equilibrium price if market frictions are sufficiently high or the market is inefficient, even if the assets are close to being perfect substitutes. Although some believe in efficient markets, they may not be ready to take an asset's daily fluctuating market price as a long-term equilibrium value due to asset-specific noises. Nonetheless, academics and practitioners have developed and applied various valuation methods in equity research practices. Some widely used methods include intrinsic valuation, such as the discounted cash flow (DCF) approach; current valuation, using market-based multiples; asset valuation, mainly for liquidation purposes; and real option valuation, incorporating option values of future decision-making in a project. As Yee (2004) notes, however, no single valuation technique has shown absolute superiority in accuracy according to previous empirical research. As a result, analysts jointly use several alternatives and practical valuation methods to increase the confidence ...