Choosing a valuation approach is the most critical decision an analyst makes. This choice is dictated by the "Valuation Mindset," which separates the world into two primary philosophies: Absolute (Intrinsic) and Relative . While both aim to answer the question "What is this worth?", they start from completely different premises.
Absolute Valuation: The Intrinsic Worth
Absolute valuation models attempt to find the "true" or intrinsic value of an investment based solely on its fundamentals . In this philosophy, the market price is irrelevant to the calculation. You are looking at the company as if it were a private island; its value is determined by the fruit it produces (cash flows) and the risks of a storm (uncertainty), not by what the island next door sold for .
The Discounted Cash Flow (DCF) Model
The DCF is the gold standard of absolute valuation. It operates on the principle that a business is worth the sum of all the cash it will provide to its owners in the future, adjusted (discounted) for the fact that a dollar today is worth more than a dollar tomorrow .
To build a DCF, an analyst must:
- Forecast Free Cash Flows (FCF): Estimate how much cash the company will generate after paying all its bills and reinvesting in its growth, typically for a 5-to-10-year period .
- Calculate Terminal Value: Estimate the value of all cash flows beyond the forecast period .
- Apply a Discount Rate: Use a rate (like the Weighted Average Cost of Capital) to bring those future sums back to their "Present Value" .
The Dividend Discount Model (DDM)
A simpler version of absolute valuation is the DDM, which is used for mature, "blue-chip" companies that pay steady, predictable dividends . The logic here is that for a shareholder, the only cash they actually receive is the dividend. Therefore, the stock's value is the present value of all future dividends . The Gordon Growth Model is a popular variant of this, assuming dividends will grow at a constant rate forever .
Relative Valuation: The Market's Mirror
Relative valuation, or the "comparables" approach, operates on the "Law of One Price," which suggests that two similar assets should sell for similar prices . Instead of forecasting decades of cash flows, you look at what the market is currently paying for similar companies using multiples .
Market Multiples and Ratios
Multiples are ratios that relate a company's market value to a specific financial metric. Common multiples include:
- Price-to-Earnings (P/E): The most common ratio, comparing the stock price to the earnings per share (EPS) .
- Enterprise Value to EBITDA (EV/EBITDA): A favorite for professional analysts because it looks at the whole business (including debt) and ignores non-cash accounting charges .
- Price-to-Sales (P/S): Useful for early-stage companies that have high revenue growth but aren't profitable yet .
- Price-to-Book (P/B): Often used for banks or companies with significant physical assets .
The Three Pillars of Relative Valuation
Conducting a relative valuation involves three distinct steps:
- Identify Comparable Companies ("Comps"): Find peers in the same industry with similar size, growth rates, and business models .
- Select Relevant Ratios: Choose the multiples that matter most for that industry (e.g., P/B for banks, EV/EBITDA for manufacturing) .
- Calculate and Compare: If the industry average P/E is 20x and your target company is trading at 15x, it might be undervalued—provided there isn't a fundamental reason for the discount .
Precedent Transactions: The Takeover Perspective
A subset of relative valuation is "Precedent Transactions Analysis." This involves looking at what acquirers paid to buy similar companies in the past . Because these deals usually include a "control premium" (an extra amount paid to take over the company), these multiples are often higher than the multiples of stocks trading normally on an exchange .
Choosing the Right Philosophy
The "best" approach often depends on the type of company and the data available.
| Company Type | Preferred Approach | Why? |
|---|---|---|
| Mature, Stable Firm | Absolute (DCF or DDM) | Cash flows are predictable and easy to forecast . |
| High-Growth Startup | Relative (P/S or EV/Sales) | Negative earnings make P/E and DCF difficult or impossible . |
| Asset-Heavy (e.g., Real Estate) | Absolute (Asset-Based) | Value is tied to the fair market value of physical holdings . |
| Bank or Financial Institution | Relative (P/B Ratio) | Book value is a more accurate reflection of a bank's worth . |
The Danger of Isolation
Bridger Pennington, co-founder of Fund Launch, notes that "Valuation isn't done in isolation; it's guided by how similar companies are trading" . However, relying only on relative valuation can be dangerous. If an entire sector (like the dot-com bubble) is overpriced, a company might look "cheap" compared to its peers while still being fundamentally overvalued . Conversely, absolute valuation is only as good as its assumptions; if your growth forecasts are too optimistic, your "intrinsic value" will be a fantasy . Most professionals use a mix of both to get a complete picture .
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