Absolute Valuation (calculating Intrinsic Value)
In absolute valuation of a stock, the worth of a business is calculated. This is the Intrinsic Value.
The Intrinsic Value can be estimated from various ways, the two common ones are::
Relative Valuation
Some common market ratios for valuations of stock are PE, EV/EBIT, EV/EBITA, P/B and P/S. The problem is these are all based on price; comparing what an investor is paying for a stock to what he is paying for another stock.
Relative valuation does not tell you the Intrinsic Value (IV) of the stock. Without knowing the IV, at least an estimated one, the investors do not really know what price should be paid for it.
Absolute Valuation versus Relative Valuation
Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the IV of a company gives us a better understanding of its value and hence the price we are willing to pay for it.
Having an estimated IV also helps us focus more on the value of the business, rather than the price of the stock which changes every minute on the screen.
It gives us a stronger basis for making investment decisions.
Discounted Cash Flow Analysis (DCFA)
Discounted Cash Flow Analysis (DCFA) is a method of valuing the intrinsic value of a company.
DCFA tries to work out the value today, based on projections of all the cash it could make available to investors in the future.
It is descried as "discounted" cash flow because of the principle of "time value of money" - that is, cash in the future is worth less than cash today.
DCFA starts with the premise that a stock's price should be equal to the sum of its current and future cash flows after taking the time value of money (discounted by an appropriate rate) into account. (John Burr Williams).
Stock Price IV
= Sum of the Present Value of All Future Free Cash Flow (FCF).
Advantages of DCFA
Weakness of DCFA
Reference:
Page 256 to 265 The Complete VALUE INVESTING Guide That Works! by K C Chong
Also read:
In absolute valuation of a stock, the worth of a business is calculated. This is the Intrinsic Value.
The Intrinsic Value can be estimated from various ways, the two common ones are::
- from the assets* the company owns, and the other,
- from its expected future cash flows (also known as the discount cash flow analysis).
Relative Valuation
Some common market ratios for valuations of stock are PE, EV/EBIT, EV/EBITA, P/B and P/S. The problem is these are all based on price; comparing what an investor is paying for a stock to what he is paying for another stock.
Relative valuation does not tell you the Intrinsic Value (IV) of the stock. Without knowing the IV, at least an estimated one, the investors do not really know what price should be paid for it.
Absolute Valuation versus Relative Valuation
Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the IV of a company gives us a better understanding of its value and hence the price we are willing to pay for it.
Having an estimated IV also helps us focus more on the value of the business, rather than the price of the stock which changes every minute on the screen.
It gives us a stronger basis for making investment decisions.
Discounted Cash Flow Analysis (DCFA)
Discounted Cash Flow Analysis (DCFA) is a method of valuing the intrinsic value of a company.
DCFA tries to work out the value today, based on projections of all the cash it could make available to investors in the future.
It is descried as "discounted" cash flow because of the principle of "time value of money" - that is, cash in the future is worth less than cash today.
DCFA starts with the premise that a stock's price should be equal to the sum of its current and future cash flows after taking the time value of money (discounted by an appropriate rate) into account. (John Burr Williams).
Stock Price IV
= Sum of the Present Value of All Future Free Cash Flow (FCF).
Advantages of DCFA
- It produces the closest thing to an intrinsic value of a stock.
- DCF method is forward looking and depends more on future expectations than historical results.
- This method is based on FCF which is less subject to manipulation than some other figures and ratios calculated out of the financial statements.
Weakness of DCFA
- It is a mechanical valuation tool and is subject to the principle of "garbage in, garbage out."
- In particular, small changes of inputs in cash flows and discount rate can result in large changes n the value of a company.
- Hence, IV obtained is never absolute and infallible, but rather an approximation.
Reference:
Page 256 to 265 The Complete VALUE INVESTING Guide That Works! by K C Chong
Also read:
* Warren Buffett Explains Why Book Value Is No Longer Relevant
http://myinvestingnotes.blogspot.com/2020/03/warren-buffett-explains-why-book-value.html
