Why Analysts’ Valuation Does Not Apply To Retail Investors?

Not many retail investors do their own valuation analysis when investing in the stock market.  Some rely on news, technical analysis or analyst’s report.  In many analysts’ reports, especially those who use discounted cash flow method or dividend discount model (DDM), the stock value is estimated based on certain assumptions, which may not be applicable to retail investors.

One of the key factors in valuation is the required rate of return, k.  It is inversely proportional to the value of the stock.  There are few methods to estimate k, the most common one is Capital Asset Pricing Model (CAPM).

The formula for CAPM is

where,

k = required rate of return

R_f = Risk Free Rate

β = Beta

R_m = Market Return

R_f and R_m are the invariant to all investors.  The factor that differentiate analyst and retail investor is the β.  Beta (“β”) is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors.  β is measured through the eyes of the marginal investor in equity (rather than the retail investor). The marginal investor is an investor who owns a well-diversified portfolio and trades frequently, for example, a Fund Manager.

If you are a retail investor who does not hold a well-diversified portfolio, the beta has to be adjusted to reflect your risk.  Aswath Damodaran, the valuation guru from NYU Stern Business School, stated that “total beta” is more appropriate for the average investor (Read more here).   The “total beta” is derived by dividing the beta with the correlation coefficient of the stock and the market portfolio.

The mathematics involved in calculating “total beta” may be discouraging, so what could a retail investor do in order to correctly adjust for the risk?  Since the correlation coefficient is always less than 1, which means the “total beta” will be always higher than beta.

As such, the required rate of return, k, is relatively higher for a retail investor.  This means that the value of the stock from the eyes of retail investor shall always be lower than the number reported by an analyst!