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.
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:
This method has the following advantages:
The following are some disadvantages of this method:
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:
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.