The Issue of Using Averages for Pricing Individual Assets
It is will only be right for the few assets that are average in nature. This is because some assets will trade at above some average due to valid reasons, while some will trade below for valid reasons. Using the simple averages, we completely ignore that and could make wrong buy and sell decisions.
If the markets are efficient, it will not make a difference what we buy or sell. But if markets are not efficient, it will matter.
A simple example for illustration is calculating the fair stock price by multiplying the current earnings by an industry average price-to-earnings ratio. Using this example, I will show the problem that arises when using averages.
The simple formula for calculating the fair share price is the following:
Estimated fair share price = current earnings * earnings multiple (p/e ratio)
Assume now, we can chose to invest in stocks of company A,B, and C.
| Company A | Company B | Company C | Time: now |
| Current Earnings |
100 |
100 |
100 |
| Current true fair value (which we are trying to estimate) |
700 |
1000 |
1300 |
| Scenario 1: Efficient Public Market Current Price Current P/E |
700 7 |
1000 10 |
1300 13 |
| Scenario 2: Private sellers, no public market Current Price Current P/E |
800 8 |
1000 10 |
1200 12 |
| Time: 1 year in the future | |||
| Future Earnings |
110 |
110 |
110 |
| Future true fair value |
770 |
1100 |
1430 |
| Scenario 1 & 2 (assume companies went public for Scenario 2): Public Market Market Price Future P/E |
770 7 |
1100 10 |
1430 13 |
In Scenario 1, we have an efficient public market. Nevertheless, we think we can outsmart the market with our formula to calculate share prices as mentioned above. The industry average p/e is 10, calculated as (7+10+13)/3 = 10. So our estimation of the underlying true fair value for a stock of company A is 1000, for company B 1000, and also for company C 1000. Based on that, we decide to buy only 3 stocks of company A. We pay 2100 and are looking forward to make a gain of 900 when the stock price converges to our estimates fair value. A year later, we sell the 3 stocks for 2310 (3*770) with a gain of only 210 (return on invested capital is +10% calculated as 210/2100).
In Scenario 2, there is no efficient public market. But the stocks are offered in private markets. Our estimated fair value for company A, B, and C stays the same with 1000. This is based on an industry average p/e of 10 calculated as (8+10+12)/3=10. Based on that we decide that company A is a good buy (with 750 significantly below our estimated fair value of 1000), B is neutral, and company C should be sold. We decide to buy 3 shares of A and go short 1 share of C. One year later, all 3 companies went public and there is now an efficient public market. We close our positions with a loss of 90 for company A stocks (3*(800-770)) and a loss of 130 for our short position in company C stocks. The total return is -210 ( -18%, calculates as 90/(3*800-1200)).
To sum up, the use of industry average p/e has lead us to buy the over-priced asset and sell the under-priced asset, which is exactly the opposite of what would have made money.
Of course, it is sometimes helpful to use averages to price assets. When valuing a company, it could be used to price the value of some non-operating investments and similar items. However, care must be taken, that these items will not constitute a large part of the final asset value, else the issue described above will start to become significant. For example, valuing a company 5 years into the future in detail and then using an industry average for the remaining years would not be a good choice, as the remaining years probably constitute the major part of the stock's value.
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