Intrinsic values, market values and efficiency : an analysis of Maltese bank stocks

Abstract

Purpose: This dissertation sets out to test the extent to which the market values of local bank stocks are suitable appraisals of their underlying intrinsic values, with the ultimate aim of determining whether such stocks are overvalued or undervalued. The study seeks to interpret the results vis-à-vis the adequacy of the valuation model implemented and the implications for local stock market efficiency. Design: From a methodological viewpoint, the main innovation of this dissertation lies in the fact that a scenario analysis approach was adopted in deriving the stocks’ fundamental values, by examining the banks’ historical dividend-paying capacity. To this extent, a range of intrinsic values was derived for each stock using a suitable variant of the Dividend Discount Model (DDM), since the model’s parameters, such as the cost of equity and the terminal values, were estimated under various scenarios. In particular, the cost of equity was calculated under daily, monthly, and annual return intervals; while the terminal values were appraised using two methods, termed the Share Price Method and the Stable Growth Rate Method. Findings: Under most scenarios, the shares appear to be overvalued when compared to the intrinsic values derived from the non-constant growth DDM, which was deemed to be the optimal model to be applied locally. Furthermore, in general, a considerable proportion of the derived intrinsic values is attributable to the terminal values, although the Stable Growth Rate Method appears to fail for non-dividend-paying stocks. Indeed, the intrinsic values derived from the Share Price Method show greater convergence to market prices, signifying the potential superiority of this method. Conclusions: The fact that shares appear to be overvalued leads to a twofold interpretation. Primarily, intrinsic values may be underestimated due to model specification errors. Alternatively, these results could reflect the fact that the composition of share prices may only partially be traced back to their economic fundamentals. In turn, this points towards the potential inefficiencies that may be present in the local stock market. Value: This fundamental analysis presents evidence of potential stock mispricing on the Malta Stock Exchange, the effect of which may theoretically be diluted through the process of arbitrage. Thus, if the market is unconstrained by limits to arbitrage and behavioural factors, this study may be a contributor towards the enhanced efficiency of the Maltese stock market.