Relative and Intrinsic Stock Valuation: 5 Key Methods

Thursday, Jan 26 2012 by
Relative and Intrinsic Stock Valuation 5 Key Methods

Valuation is, of course, fundamental to investing. Knowing what an asset is worth and the drivers of value is a pre-requisite for intelligent investing (as opposed to speculation). In general, there are two basic methods for valuing stocks. One approach is relative valuation, which compares a stock's valuation level based on multiples like the Price Earnings ratio with those of other stocks (known as 'comparable companies') or versus the company's own historical valuation levels. 

The alternative approach is absolute, or intrinsic, valuation. This is based on the economics of the company itself, and not on its current price. It is usually calculated by calculating the present value of the company's future free-cash flows (cash flow minus capital spending). This approach is much more aligned with the perspective of value investors. As Benjamin Graham wrote, "Price is what you pay, value is what you get". His point was that, when you buy a stock, you are buying ownership of a business with real assets. Should that really change just because the market is moody or plagued by worries about liquidity? On this view, as long as the fundamentals are sound, the daily ups and downs in the markets should not alter the value of what you own.

Valuations are mainly relative....

In practice, though, most valuations are relative valuations. This is most likely because multiple-based methods are are simple and easy to relate to.According to Damodaran, a finance professor at NYU, almost 85% of equity research reports are based upon a multiple and comparables, and more than 50% of all acquisition valuations are based upon multiples. He notes that, even discounted cashflow valuations used in consulting are often relative valuations masquerading as discounted cash flow valuations (the objective being to back into a number that has been obtained by using a multiple). As subscribers toStockopedia Premium will know, we have a Relative Value calculator for each stock in the market that allows you to derive an indicative valuation versus the sector based on a range of different multiples. 

Despite its ubiquity, it's important to recognise that relative valuation is plagued with issues. Firstly, it relies on accurate comparisons but no two firms are ever exactly similar in terms of their risk and growth profile. Secondly, when the companies you're using as a benchmark are themselves mispriced (e.g. because of a bubble), relative…

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