Absolute Valuation Models Vs Relative Valuation Models
Equity valuation can be conducted using two broad types of models. Of course, each type of models has their own subtypes. However, when it comes to broad classification, there are really only two types of approaches possible. One of them is called the absolute valuation approach whereas the other is called the relative valuation approach. In this article, we will explain the difference between these two types of approaches.
- Absolute Valuation Models:
The defining characteristic of an absolute valuation model is that in this model the value of the asset is derived only on the basis of characteristics of that asset. There is no consideration regarding the valuation of other comparable assets that are trading in the marketplace. These models are basically known as the “discounted cash flow” of the DCF models. These models are widely used across the industry. There are several subtypes of discounted cash flow models which we will discuss now:
Discounted Dividend Models:Discounted dividend models assume that the shareholders of the firm are only entitled to its dividends. Thus, these models assume the purchase price of the share as the initial negative cash outflow and then assume that dividends that will be received throughout the life of the firm are the positive cash flows. Based on the dividends that are expected to be received later, it is decided whether an investment is worthwhile given its current market price.
Discounted Free Cash Flow Models:The discounted free cash flow models differ from the discounted dividend models in the sense that a broader concept of cash flows is being used. These models look at the total cash flow that will accrue to the firm. Then they subtract the amounts that are owed to outside parties like government, bondholders etc. They balance amount is considered free cash flow to the firm. This is projected for several years and then discounted to arrive at the valuation of the firm.
Discounted Residual Income Models:Discounted residual income models look at an even broader concept of cash flows. They just consider all the cash flows that accrue to the firm post the payment to suppliers and other outside parties. Payments due to bondholders and preference shareholders are also not subtracted from the total. The residual cash flow is then discounted to arrive at the valuation of the firm.
Discounted Asset Models:A slightly different absolute valuation model is the discounted asset model. In this case, the valuation is conducted based upon the market value of the assets that the firm currently owns. The present value of each asset is derived and then all the values of all the assets are added up to come up with a value for the entire corporation. This method does not take into account the synergy between the assets. As such, it can only be used for commodity businesses which involve oil, coal or other such natural resources.
We can see that in all the above models, different variations of the cash flow are being discounted. They are pretty much the same apart from the fact that different cash flows also mean different risk and therefore different discount rates need to be applied to these cash flows to arrive at the appropriate valuation.
Relative Valuation Models:Relative valuation models are different from discounted cash flow models. They are different in the sense that they do not value a firm or an asset based on what its intrinsic value is. Rather, these models believe that the market may be wrong about a given stock. However, for an industry in general the market is right.
Hence, the approach followed in relative valuation models is to find a benchmark valuation. Let’s say that when we make an index of all the stocks in the technical industry, we get a market price to earnings ratio of 25. This means that the market believes that each stock is worth approximately 25 times what its current earnings are.
Next, we look at a particular stock. Let’s say the stock of Yahoo Inc. We see that Yahoo is valued only at 17 times its earnings even though the market is valued at 25 times its earnings. We then study the details of Yahoo’s business to find legitimate reasons as to why it should be so undervalued. If the reasons are found, then the stock is trading at fair value.
However, if there is no cause for the stock to trade at a lower P/E than the market, then we assume that this is a market anomaly and that Yahoo shares are trading below their fair value, making them a good buy.
There are many variations of relative valuation models as well. Instead of using price earnings ratio, we could use price to sales ratio, price to book value ratio, price to cash flow ratio or any number of ratios.
Each of these models, have a lot of detailed explanation that needs to be given before they can be finally implemented. This explanation will be given in the later articles. The purpose of this article is to provide a broad overview and give a basic introduction.
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