Company valuation techniques

Absolute vs Relative valuation explained

Investment companies spend a tremendous amount of resources on valuation infrastructure. The game is simple - how accurately can they answer the million-dollar question: Buy, Hold, or Sell? 

Buy the right stock (at the right time) and you will feel like a superstar. Life is good, your coworkers believe youre a genius, your wife is happy, and the Boss Man invites you to have a seat at the Big-Boys table. Buy the wrong stock (even worse, at the wrong time) and youll be kicking yourself for weeks. There is a great deal of money and emotions involved in this industry. It all comes down to how accurately your model can predict the future.

Valuation approaches

One can easily become overwhelmed by the number of valuation techniques and models available in the market. Unfortunately, there is no single method that trumps the rest. Each company, industry, sector, and scenario have unique characteristics. There are two distinct approaches that one can take to analyze a company Absolute valuation and Relative valuation techniques. 

Absolute valuation

When using the absolute valuation approach, analysts aim to determine the true value (also known as the intrinsic value) of a stock. In this valuation method, the idea is to zoom in and digest the fundamentals of a company, without looking at other companies. Absolute valuation models focus on a companys fundamentals, such as financial statements, dividends, cash flows, growth rates, company management etc. Once the intrinsic value of a company is calculated, it is compared to the market value to determine whether a stock is undervalued, fairly valued or overvalued. 

Lets say Company ABC currently trades at 120c per share. Our analyst calculates the intrinsic value of ABC to be 150c a share. This means that we believe ABCs share is worth 150c, whilst the demand and supply in the market value it at 120c per share. This is a clear BUY signal, as we expect the market price to converge to its intrinsic value over time.   

Relative valuation

When using relative valuation techniques, the goal is to compare different companies across the board using standardized valuation metrics. They can tell us a lot about a companys financials, without us even knowing which company it is or what line of business they operate in. Some of the most popular metrics include the Price-to-Earnings (P/E), Price-to-Sales (P/S), Dividend Yield, and Debt-to-Equity.

Lets say company A has a P/E of 12, whereas company B has a P/E of 35. Company As P/E indicates that it is relatively cheaper to buy because shareholders pay less per dollar of earnings. However, we must be very careful to draw conclusions on one indicator alone. It is important to assess a variety of ratios to better understand the bigger picture. 

Final thoughts:

To get a simple answer to a very complicated question: Should we buy, hold, or sell. I always try to keep it simple, but it is important to acquire as many data points as possible when valuing a company. Build a model that works for you and improve your model as you go.  Personally, I start with absolute valuation (fundamental analysis), followed by technical analysis, followed by relative valuation techniques. I use this combination to make the most informed decision possible.