Valuation techniques for analyzing exchange traded funds are much like evaluating single stocks. A valuation focused view can help an investor make decisions and discern expected returns to help with asset allocation.
“Even the most avid proponents of passive investing estimate expected returns for various asset classes when establishing their strategic asset allocation. Active investors with more of a tactical bent are likely to rely on valuation metrics to a greater extent,” John Gabriel for Morningstar wrote. [ETFs and Tactical Asset Allocation]
Two of the most common valuation methods are relative valuation and fundamental valuation. Generally, using both methods on a single investment can be insightful.
With fundamental valuation, the discounted cash flow analysis is the basis. The value of the stock is determined by the present value of its expected future cash flows, which are discounted back at a rate that reflects the uncertainty of those cash flows. [Morningstar on How to Build a Core ETF Portfolio]
This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.