By comparing estimates of value and market price, an analyst can arrive at one of three conclusions: The security is undervalued, overvalued, or fairly valued in the marketplace.
In practice, the conclusion is not so straightforward. Analysts must cope with uncertainties related to model appropriateness and the correct value of inputs. An analyst’s final conclusion depends not only on the comparison of the estimated value and the market price but also on the analyst’s confidence in the estimated value (i.e., in the model selected and the inputs used in it). One can envision a spectrum running from relatively high confidence in the valuation model and the inputs to relatively low confidence in the valuation model and/or the inputs. When confidence is relatively low, the analyst might demand a substantial divergence between his or her own value estimate and the market price before acting on an apparent mispricing.
