Watch out for these biggest mistakes in identifying fair value of a stock

After taking this decision, he felt proud that he had struck a ‘fair value’ deal. However, after coming back home, he checked the potatoes and found that some of the potatoes were rotten and stinky. This made him realize that ‘price is not value’.

Similarly, in the stock market, many investors make the mistake of perceiving the fair value of the stock when it trades at a discount to its recent high. Having bought a stock with a recency effect of assuming the immediate past winners to keep winning in future, an investor buys the last bull market stock on every decline, not realising that stocks ought to be bought when they are going up on improving fundamentals, rather than buying when they are going down on a weakening perception.

The price of a stock echoes both the fundamentals as well as the perception (emotions) of the market participants.

So, never mistake the bottom of the chart as the support for the stock price. The downtrend may continue. Just because the stock is 40-50% off from its high does not mean that it is attractively valued. It is just not possible to know what is driving the vicious downtrend and there is every possibility that the stock may move lower after falling significantly from the high point.

When a trending stock falls from its top, the first impression it creates is that of a big discount sale. But most investors do not realise that stocks don’t become bargains just because they have tumbled 50% from the top. A stock that is falling because of forced market liquidation post a dream run or a bullish phase will, in all probability, go below the perceived fair value of the stock. This is how market participants get trapped in a wrong perception of value.

The DHFL stock is a classic illustration of such a wrong perception. When the DHFL stock declined 74.5% from its peak, many market participants would have made the blunder of buying into the stock. They would have perceived some value in the stock just because it traded at a hefty discount of 74.5% from its top.

If anyone had bought the stock even after the 74.5% decline from its top, they would have further lost 45% of their investment in the second round of its fall. Adding insult to injury is the fact that even after such a steep fall, there was no value in the stock as the stock took a further beating of 84% in the third phase of decline and in the final phase the stock price was pushed below the single digit mark as the stock declined further by 45%.

So, despite witnessing an average fall of 50% at each stage, there was no value left in the DHFL stock at all. In the entire process, the stock depreciated by 98.79% of its peak value.

Conclusion: The establishment of a past high price provides a strong anchoring bias for the investors to get sucked in. This, coupled with the pain of having missed the flight on the way up, compels them to get in on the way down. Hence, more investors bought stocks like

and DHFL after they made their long term peaks than they did before it.

So, if you are using percentage fall from high as a barometer for ascertaining the value of a stock, it is high time you changed your methodology. With this change, you will see a change in your portfolio returns.