Analysts' secret weapon: Absolute valuation

Investing with moomoo wrote a column · Jul 7, 2021 15:55

Analysts' secret weapon: Absolute valuation

You may have seen analysts giving enterprise valuations in their reports or news on one institution raise or lower the target price of certain companies. These figures definitely didn’t come out of the blue, so how are they calculated?

There are 2 categories of valuation methods, absolute valuation and relative valuation. In this article, we will discuss what absolute valuation is and how it works.

What is absolute valuation?

Absolute valuation models aim to find a company's intrinsic value based on fundamental analysis. You only focus on the company's performance, such as profit, cash flow, dividend, instead of looking at its competitors. Discount model, discounted cash flow model, residual income model, and asset-based model are popular absolute valuation models.

Popular absolute valuation models

There are 2 most commonly used models, the DCF model and DDM.

Discounted cash flow model (DCF)

A company's value consists of all the cash flows it obtains in the future which are discounted back to today.

The Two-Stage DCF model is most commonly used. Free cash flows are forecasted for 5 to 10 ten years and then the terminal value is used to account for all the cash flows ever after.

Requirements:

First, the company should have positive and predictable cash flows. High capital expenditures could lower cash flows to negative. Thus, high-growth companies and small non-mature companies with high capital expenditures might not be suitable for this method. It could be extremely difficult for us to determine when the cash flow turns positive and negative company value is unrealistic.

Dividend discount model (DDM)

DDM is simpler and more straightforward than DCF. It uses a company’s dividend payments to calculate the true value of the company since dividends represent the actual cash flows going to the shareholder, so the present value of these cash flows represents how much the shares should worth.

Requirements:

The first step is to make sure the company pays dividends. If not, then you could only use alternative methods.

Then, it is important to check if the dividends are stable or predictable. For example, the dividend could grow at a consistent rate or as a fixed percentage of EPS.

Limitations

No single valuation model fits all situations, just like you can't use 1 financial ratio to analyze all companies. You should decide which method fits the specific company before building models.

However, these models could help you better understand the company. Also, you could utilize many models together to arrive at a range of company values.

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