Absolute Value

What exactly is Absolute Value?

It is an approach to assessing the financial worth of a company that employs discounted cash flow (DCF) analysis.

The absolute value method differs from relative value models, which consider how much a company is worth in relation to its competitors. Absolute value models attempt to calculate a company's intrinsic value based on projected cash flows.

Understanding Absolute Values

Value investors are primarily concerned with determining whether a stock is undervalued or overvalued. So, value investors often use popular indicators such as the price-to-earnings ratio (P/E) and the price-to-book ratio (P/B) to determine whether to buy or sell a stock based on its perceived value. In addition to using these ratios as a reference, a discounted cash flow (DCF) valuation analysis helps establish absolute value.

A DCF model estimates a company's future cash flows (CF), which are then discounted to present value to determine the company's absolute value. The present value is regarded as the firm's genuine worth or intrinsic value. By considering these figures, investors can determine whether a stock is currently undervalued or overvalued by comparing the share price of a company, given its absolute value, to the price at which the stock is currently trading.

What are the various Absolute Value Model Types?

Dividend Discount Model

It is often used when a company has a track record of paying consistent dividends linked to earnings.

Based on the dividends expected to be collected, it is determined whether an investment is worthwhile at its current market price. In this model, the stock price is the present value of all future dividend payments.

Discounted Cash Flow Model

It is a method of valuing security, project, company, or assets using time value of money concepts.

To calculate intrinsic value, DCF (discounted cash flow) takes the present value of the sum of expected future cash flows into consideration and discounts it back at the appropriate cost of capital.

This method is used by professional investors and analysts when determining the fair price to pay for a company, whether for individual shares of stock or the entire organization.

The company's enterprise value is calculated using FCFF (free cash flow to the firm) in DCF valuation. In this valuation, it is assumed that the money is still available to the company's investors, which include bondholders and stockholders.

FCFE (free cash flow to equity) is also used in DCF valuation to determine a company's equity value or intrinsic value for common equity shareholders. FCFE is the amount that remains for the company's joint equity holders.

WACC (weighted average cost of capital) is used in DCF to calculate how much it costs a company to raise capital through bonds, long-term debt, common stock, and preferred stock.

Discounted Residual Income Model

The cost of equity capital is explicitly considered in residual income valuation. This method contrasts with the return on investment (ROI) method.

This model only considers the company's cash flows after paying suppliers and other external stakeholders.

Payments made by bond and preference shareholders are not deducted from the total amount. The firm's valuation is then determined by discounting the remaining cash flow.

Economical Profit Model

It is a metric that compares net operating profit to total capital costs. To generate financial profit, revenue is discounted by direct and opportunity costs.

The net operating profit after tax (NOPAT) is shown on the corporation's income statement. The money used to fund a specific project is known as the capital invested.

We will also need to calculate the weighted-average cost of capital if the data is not already available.

Absolute Value vs. Relative Value

A relative value is the inverse of an absolute value. While absolute value considers the intrinsic value of an asset or company without comparison, relative value considers the importance of similar assets or companies. Analysts and investors using relative value analysis for stocks examine financial statements and other multiples of potential companies and compare them to similar firms to determine whether those likely companies are overvalued. Assume an investor wants to know Walmart's relative value. In that case, they will examine the variables-market capitalization, revenues, sales figures, P/E ratios, and so on-in comparison with companies such as Amazon, Target, and/or Costco.

Special Considerations

Estimating a company's absolute value is often challenging. It is difficult to predict cash flows with absolute certainty and to estimate how long they will continue to grow. Apart from predicting an accurate growth rate, determining an appropriate discount rate to calculate the present value can be time-consuming and labor-intensive.

Because the absolute valuation approach to determining the worth of a stock is solely based on the company under consideration's characteristics and fundamentals, no comparison to other companies in the same sector or industry is made. When analyzing a firm, however, companies in the same sector should be considered because any market-moving activity-bankruptcy, government regulatory changes, disruptive innovation, employee layoffs, mergers and acquisitions, and so on-in any of these companies can affect how the entire sector moves. As a result, combining both the absolute and relative valuation methods is the best way to determine a stock's real value.

Advantages and Disadvantages of Absolute Value

An absolute value is a valuation technique used to assess a company's financial health. The goal of absolute value methods is to determine the economic value of a company based on its inherent values or anticipated future cash flows. Since it has several models, it has certain advantages and disadvantages. Let's take a look at some of the benefits and drawbacks of using this valuation method:

Advantages

This method has the following advantages:

• The dividend discount model has the advantage of requiring fewer assumptions when valuing a company because distributions tend to remain stable over long periods.
• A DCF's moving parts include free cash flow, the discount rate, and the terminal value. This allows the appraiser to use their best judgment and the relevant case data to narrow down their estimate of the value of the appraised company.
• After deducting taxes, capital expenses, working capital, and other expenses, free cash flow is widely regarded as the most accurate method of calculating cash flow available to shareholders and, in some cases, debtholders.
• Residual income methods are best when a company does not pay dividends or expects a negative cash flow.
• The CAPM (capital asset pricing model) model assumes that the investor has a diversified portfolio, similar to a market portfolio. Diversifying the holdings reduces unsystematic (specific) risk.

Disadvantages

The following are some disadvantages of this method:

• In the case of dividend discount valuation, this model cannot be used to value a company if it does not pay any dividends, regardless of how successful or cash flow efficient the company's operations are.
• A DCF is generated by making predictions about a company's potential performance based on current information. The analyst must recognize this fact and then choose an appropriate discount rate in light of it. Because the inputs are so sensitive when using a DCF, the value can easily be overstated.
• The accounting data on which the residual income approach is based can be easily manipulated.
• Many people believe that the CAPM model is unrealistic because it is based on too many assumptions. As a result, the results may not be so accurate.

Selecting a Valuation Method

The variety of stock valuation methods available to investors can easily overwhelm someone evaluating a stock for the first time.

While some valuation techniques are straightforward, others are more complex and difficult. Each company is distinguishable, and each industry or sector has characteristics that may necessitate different valuation techniques.

Because valuation is an art, we have rules to follow when selecting a valuation model. Following are some of the major factors to be kept in mind while selecting an effective evaluation method:

Characteristics of the Organization

One important factor to consider when deciding which model to use for the valuation process is the organization's characteristics. The first step in the valuation process is to understand the business. When we know the industry, we understand the nature of its resources and how it uses them to generate value.

For example, the asset valuation model must be abandoned if the organization has assets that it can buy and benefit from or if the assets are primarily intangible. Another important factor to consider when deciding which model to use for the valuation process is the investor's characteristics.

Analysts' and Investors' Goals or Perspectives

Another important factor to consider when choosing a valuation model is the analyst's viewpoint. For example, the ownership perspective can influence the valuation methodology selected.

Analysts must consider various biases when analyzing information created by others, such as:

• Why was this particular appraisal method chosen?
• Are the assumptions and valuation models sound balanced?

Investors may purchase private companies to later sell them by going public. In such a case, the valuation will be entirely determined by the retail investor's assessment of the company's worth.

Multiple Valuation Methods

It's important to remember that investors frequently use multiple valuation models to determine a company's value rather than just one.

The advantage of using multiple models is that the analyst can check to see if all models produce comparable value measurements.

The Bottom Line

A value investor must comprehend the notion of an absolute valuation equation since it is utilized to determine if a company is overvalued or undervalued. However, accurately forecasting the cash flows and determining how long the cash flows will continue to expand in the future is extremely difficult. As a direct consequence, this method should be used with extreme caution.