Estimation error

Error that comes from imperfect inputs or models rather than from what is being measured, as in an estimated beta. In valuation, the part of a gap between value and price that is the analyst's mistake, not genuine mispricing.

Where you will meet it

Estimation error appears in 7 learning outcomes on the CFA syllabus. A few of them:

• Define intrinsic value and valuation, then explain where perceived mispricing comes from
  CFA Level II · Equities

  “Put simply, estimated value minus price equals true mispricing plus estimation error.”

• Contrast the approaches for estimating equity investors' required return
  CFA Level II · Corporate Finance

  “Each method has weaknesses: beta estimation error, judgement in premiums.”

• Set out the techniques used to forecast volatility and covariance
  CFA Level III · Asset Allocation

  “Factor models impose structure, estimating each asset's exposure to a few common factors, which reduces estimation error at the cost of possible misspecification.”

• Judge from a DDM value whether the market is pricing a stock too high, too low or fairly
  CFA Level II · Equities

  “The trap is treating a small gap between value and price as a clear signal when it lies well within the model's likely estimation error.”

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
• Free finance calculators Check your arithmetic on the exam's core formulas.

All terms beginning with E · Glossary