A Bayesian Framework for Combining Valuation Estimates

Abstract

Obtaining more accurate equity value estimates is the starting point for stock selection, value-based indexing in a noisy market, and beating benchmark indices through tactical style rotation. Unfortunately, discounted cash flow, method of comparables, and fundamental analysis typically yield discrepant valuation estimates. Moreover, the valuation estimates typically disagree with market price. Can one form a superior valuation estimate by averaging over the individual estimates, including market price? This article suggests a Bayesian framework for combining two or more estimates into a superior valuation estimate. The framework justifies the practice -- popular on Wall Street as well as in courtrooms and tax court -- of averaging over several estimates to arrive at a final point estimate.

Keywords: value investing, financial statement analysis, equity valuation

JEL Classification: C11, C40, C53, E17, G11, G12, K22, M41