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Where facts conquer fiction. Dig deep for facts. Dig deeper for value.

 

 

Evolution of Analysis

The evolution of investment analysis and analysts can be depicted as a family tree beginning at their common branch Homo sapiens sapiens (Homo s.s.). The lineages are not monolinear but rather multilinear. The stylized stages in the evolutionary path are presented in systematical rather than chronological order.

STAGE 1: Homo s.s. heuristicus: Pre-analysis.
Intuition and heuristics. Either no theory or the Greater Fool Theory.

STAGE 2: Homo s.s. graphicus: Market analysis.
Market timing. Price charts and mechanical trading rules. Advanced price charting with moving averages, head and shoulders patterns and other indicators.

STAGE 3: Homo s.s. quotienticus: Hybrid market/security analysis.
Price ratios. Includes dividend/price (e.g. Dogs of the Dow), price/earnings, price/earnings growth, price/cash flow, price/sales and price/book value.

STAGE 4: Homo s.s. statisticus: Hybrid market/security analysis.
Pricing models. Monocausal univariate capital asset pricing model (CAPM) with the market beta factor as sole explanation of risk, other univariate and multivariate inferential econometric factor models, arbitrage pricing model (APT), and option pricing theory.

STAGE 5: Homo s.s. relativisticus: Security analysis and hybrid market/security analysis.
Valuation models and pricing models. Appraisals based on comparative financial statements and comparable transactions.

STAGE 6: Homo s.s. intrinsicus: Investment analysis.
Valuation models. Includes dividend discount model (DDM) and other discounted cash flow (DCF) models, single-stage or multiple-stage models with finite horizons and normative terminal values, and models with infinite horizon.

In some individual analysts, all six stages can be observed in different circumstances. The six major types of investment analyst may be difficult to identify due to contextual protective coloration and other evolutionary strategies.

Stage 1: The primordial persona relies on instincts and common sense rules of thumb to serve as an antidote to the speculative theories of mad scholars.

Stage 2: The latent chartist persona finds confirmation in price charts through the patterns he projects into them, and interprets this divinatory power as a talent for graphical literacy or graphicity.

Stage 3: The filter feeder persona interprets superficial price quotients, designed for screening and ranking, as pricing ratios for valuation.

Stage 4: The statistician persona, an overzealous exponent of the inductive method, applies the spurious artifacts of mathematical models as substitutes for judgment.

Stage 5: The appraiser persona takes convenient samples for the most comparable securities and transactions as benchmarks for relative pricing.

Stage 6: The evaluator persona makes forward looking assumptions that provide wide leeway in justifying the conclusions.

As can be observed, each stage has its limitations and potential for misuse.

Valuation models by definition are independent of even the existence of a market. Any investment model that contains market-generated data is necessarily a pricing model and not a valuation model. There are no market variables in a valuation model except for the inclusion of normative, as opposed to positive, benchmarks of terminal selling price when assuming a finite investment horizon. Hybrid models are therefore pricing models that are mislabeled if called value models or valuation models. Such mislabeling may be an unwitting mistake made in good faith, or it may be protective coloration to attract a different audience and clientele. Caveat emptor!

 


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