Can a firm be overvalued and undervalued at the same time?

The answer is Yes! Confused? Let us first look at the background of valuation.
Valuation is defined by Investopedia as- The process of determining the current worth of
an asset or company. Analysts value businesses for a number of reasons. Valuation can
be measured using various techniques and models. Broadly they can be classified in
four ways:
1.
2.
3.
4.

Asset based valuation approach

Discounted cash flow valuation approach
Relative valuation approach
Option pricing approach

(Source: Damodaran on Valuation)

Now, if one values a firm using discounted cash flow and relative valuation models, one
may very well get different answers using the two- the firm may be undervalued using
the relative valuation models but overvalued using discounted cash flow models.
What does one make of these differences, and why do they occur? If a firm is
overvalued using a discounted cash flow method and undervalued using the relative
valuation, it could be an indication that the sector is overvalued relative to its
fundamentals. For instance, in March 2000, Amazon was valued at $30 a share using a
discounted cash flow model, whereas actually it was trading at $70 a share; hence it
was overvalued. At the same time, a comparison of Amazon to other firms of the dotcom industry suggested that it was undervalued relative to these firms.
If a firm is undervalued using a discounted cash flow model and overvalued using the
relative approach, it may be indicated that the sector is undervalued. Again taking the
same example, by March 2001, Amazons stock was down to $15 a share but the value
of other internet stocks had dropped by a whopping 90%. Then, the discounted cash
flow method suggested that the company was undervalued, but a relative valuation
indicated that it was now overvalued that the sector.
As an investor, one can use both the above stated techniques. Optimally, one would like
to buy a share which is undervalued using both approaches. That way one benefits from
market connections, both across time (which is the way one could go for buying a new
house) and across companies (which is the path to success in relative valuation).
Why do firms do this? For example, if a company is being acquired by another one, then
it will try and portrait itself as being overvalued (whereas in reality the value of the firm
could be much lower). Hence with this, not only will the company receive a lot money in
exchange of goods, but also can get rid of the existing one and go for a new one!