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Evaluate the use of heuristics in valuing a firm

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Consider the following excerpt from a prudential report on Wal-Mart, dated May 13, 2003. The report states:

We are maintaining our Hold rating on Wal-Mart as we believe the stockâ??s current valuation of 28 times our 2003 EPS estimate of $2.01 adequately reflects the company 13% 5- year EPS growth rate...Wal-Mart is currently trading at 28.2 times our2033 estimate of $2.01,a 57% premium to S&P 500. This is not far from the retailerâ??s five-year average high premium of 59%. The stock is also close to its 52-week high of $59.30, achieved in May 2002. It is difficult for us to envision investors paying an even larger premium, particularly for 13% projected growth. We believe the stock will continue to hover around a 55% premium to market multiple or 27.9 times. Using this valuation and our 2003 EPS estimate of $2.01 yields 12-month price targets of $56, up from $55.

Discuss the merits of the valuation technique mentioned in this expert, with reference to the contents of the chapter. Base your discussion on the following questions.
- Is using a heuristic necessarily wrong in respect to valuation?
- Do you think eBay is an anomalous case, and are there situations where the use of heuristics makes sense?
- Is valuation part science and part art?
- What advice would you give financial managers when it comes to valuing their firms?

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The expert evaluates the use of heuristics in valuing a firm.

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Answer:

Is using a heuristic necessarily wrong in respect to valuation?

Heuristic approach of valuation is sometimes good but sometimes a bad measure of valuation if we look at the good part, we can find that it is easy and efficient way for valuation. It helps for short term decision making.
If we look at the wrong part we can find that it's a rough estimate hence don't give a true picture of valuation. An investor should not ...

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Jayant Kumar, MBA
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  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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