Absolute vs relative valuation – Choosing the best method for stock valuation

Stock valuation is the process of determining the intrinsic or theoretical value of a company’s shares. This evaluation is crucial for investors as it helps them make informed decisions regarding buying, selling, or holding stocks based on their perceived worth compared to market prices.

Importance of Stock Valuation

1. Informed Investment Decisions: Stock valuation allows investors to assess whether a stock is overvalued, undervalued, or fairly priced. This understanding is essential for making strategic investment choices that can maximize returns and minimize risks.
2. Identifying Growth Potential: Valuation techniques help investors identify companies with strong growth potential. Recognizing such opportunities can lead to higher returns as these companies grow and their stock prices increase.
3. Risk Assessment: Understanding the intrinsic value of a stock aids in evaluating the risks associated with an investment. Factors such as market conditions, competition, and economic changes can significantly affect a stock’s value, and proper valuation helps in anticipating these risks.
4. Market Behaviour Understanding: By analysing stock valuation, investors can better interpret market behaviours and trends. This knowledge allows them to make timely decisions based on predicted future price movements.

When it comes to stock valuation in the share market, investors typically rely on two primary methodologies: absolute valuation and relative valuation. Each method has its unique characteristics, advantages, and disadvantages, making them suitable for different scenarios.

Absolute Valuation Meaning

Absolute valuation seeks to determine a stock’s intrinsic value based solely on the company’s fundamentals. This method analyses financial statements and metrics such as cash flow, dividends, and growth rates to arrive at a theoretical value for the stock.

Common Techniques

1. Discounted Cash Flow (DCF) Model: This approach calculates the present value of expected future cash flows, making it versatile for companies with unpredictable dividend distributions.
2. Dividend Discount Model (DDM): The DDM calculates a stock’s intrinsic value based on the present value of expected future dividends. It is most effective for companies that consistently pay dividends at a stable growth rate. The Gordon Growth Model (GGM) is a simplified version of DDM that assumes a constant growth rate in dividends.

3. Residual Income Model: This approach values a company based on its net income minus a charge for the cost of capital. It focuses on the profitability generated beyond the required return, making it useful for assessing companies with significant intangible assets.

Advantages

• Provides a detailed analysis based on company-specific data.
• Useful for long-term investment strategies as it focuses on fundamentals.

Disadvantages

• More complex and time-consuming than relative methods.
• Requires accurate projections of future cash flows or dividends, which can be challenging.

Relative Valuation Meaning
Relative valuation compares a company’s financial metrics to those of similar firms in the industry. This method is often quicker and easier to compute than absolute valuation.

Common Techniques

1. Price-to-Earnings (P/E) Ratio: This widely used metric compares a company’s current share price to its earnings per share (EPS), helping investors gauge whether a stock is overvalued or undervalued compared to peers.
2. Enterprise Value-to-EBITDA (EV/EBITDA): This ratio compares a company’s enterprise value to its earnings before interest, taxes, depreciation, and amortization, providing insights into operational efficiency relative to competitors.
3. Comparable Company Analysis: This method involves evaluating similar companies within the same industry to derive valuation multiples, such as P/E or EV/EBITDA. By comparing these metrics, investors can gauge whether a stock is fairly priced relative to its peers.

Advantages

• Faster and easier to calculate than absolute methods.
• Provides a quick snapshot of how a company is performing relative to its peers.

Disadvantages

• May overlook unique company-specific factors that could influence value.
• Heavily reliant on finding truly comparable companies, which can be difficult.

How To Choose the Best Method?

The choice between absolute and relative valuation depends on various factors:

• Nature of the Company: Companies with stable cash flows and dividends may benefit more from absolute valuation methods like DCF or DDM. In contrast, growth companies or those in rapidly changing industries might be better assessed using relative methods.
• Market Conditions: In volatile markets, relative valuation can provide quicker insights into how stocks are priced compared to their peers, while absolute valuation may offer deeper insights into long-term potential.
• Investor Objectives: Long-term investors may prefer absolute valuations for their focus on fundamentals, while short-term traders might lean towards relative valuations for their speed and ease of use.

Conclusion

Both absolute and relative valuation methods have their merits and drawbacks. It is prudent for investors to use a combination of both approaches to gain a comprehensive understanding of a stock’s value. By balancing intrinsic assessments with comparative analyses, investors can make more informed decisions about buying or selling stocks in various market conditions.