Chapter 1: The Limitations of Valuation as an Asset Pricing Model

his article is based on a piece we published back in May. It has been substantially altered from its original form. More than half of the article is different that the original piece.

One thing that even advanced investors tend to overlook in their asset pricing model is the inherent limitations in using valuation to forecast future prices. This lack of awareness has lead to the proliferation of a wide array of different valuation models that while might be good at assessing intrinsic value, are for the most part worthless in projecting actual future value. Now this wouldn’t be such a big deal if it weren’t for the fact that market participants seems to conflate theoretical or normative value with actual value.

And the majority of mistakes made by investors stems largely from this unwavering stubbornness to use non-ubiquitous valuation metrics in order to justify some theoretical or abstract future value that the broader market simply does not accept. For example, some investor might believe that the price-to-sales ratio has some magical meaning, make a case for why they believe some stock X ‘deserves’ (normative) to be at some price Y, because the price to sales ratio is too low at merely 2x revenues.
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