Question

One of the most important steps in valuating a company is selecting the appropriate valuation model. There are two broad types of valuation models, a) Absolute Valuation models (Free cash flow Valuation, Dividend Discount Model), and b) Relative valuation models (e.g. market multiples or price-earnings ratios). Describe the differences between the two methods and list a few of the advantages and disadvantages of using each when valuing common stocks.

Answer 1

Absolute Valuation models find the intrinsic value of the company by discounting the potential future benefits of investing in company (such as dividends or free cash flows), and finding the present value of those future benefits, to get an estimate of the intrinsic value of the company.

Advantage - takes into account the fundamentals of the company such as the type of business, financial structure of the company, financial performance etc.

Disadvantage - Involves a lot of estimates/assumptions to be made by the analyst and hence could involve biases.

Whereas, the relative valuation models find the intrinsic value by looking at how similar companies (peers or competitors) are valued by the market, i.e. what multiples are given by the market to those peers and then finding out, what would be the value of our concerned company, if those multiples are given by the market to our concerned company.

Advantage - easier to model and find the value and it also takes into account the market perception/sentiment about the sector by the market.

Disadvantage - may get influenced by the sentiment of the market and other factors which influence the market values of stocks.