Any valuation method aims at estimating an asset’s value as precisely as possible. Yet, savvy analysts and investors know that estimating accurate asset values is highly unlikely due to market inefficiency that leads to wrong value assessments. Because markets are inefficient, assets are not priced correctly. However, as soon as new information becomes available about any asset, markets have the ability to correct themselves (efficient market hypothesis). Therefore, although market volatility makes accurate forecasting complicated, the projection of the expected cash flows in terms of growth rate or profit margin is facilitated as soon as new information becomes available for the asset. In efficient markets, the market price is the basis for estimating an asset’s value and any valuation method aims at justifying this value.
Today, most analysts use two popular valuation approaches, namely the discounted cash flow (DCF) valuation method and the relative valuation method, also known as multiples. Although they are both broadly applied tools for effective investment decision making, they differ in the way they estimate the value of an asset.
a) Discounted Cash Flow (DCF) Valuation
Discounted cash flow (DCF) valuation is based on the assumption that the value of an asset equals the present value of the expected cash flows on the asset. To do DCF valuation, analysts calculate the present value of the expected future cash flows and discount it by the cost of risk incurred by the cash flows and the life of the asset.
Discounted cash flow (DCF) valuation is based on two fundamental principles:
- Every asset has an intrinsic value that can be projected if cash flows, growth and risk are known.
- Markets are inefficient and assets are not priced perfectly, but they can correct themselves when new information about the asset becomes available.
The inputs for DCF valuation are the discount rate, the cash flows and the growth rate. Because DCF valuation can be used both for valuing equities and firms, when valuing equity, analysts use the cost of equity as a discount rate, cash flows to equity (CF to Equity) and growth in equity earnings; when valuing a firm, analysts use the cost of capital as a discount rate, cash flows to firm (CF to Firm) and growth in operating income. In both cases, growth is used to calculate the expected cash flows. Also, the discount rate can be in nominal or real terms.
One of the main advantages of DCF valuation is that by taking into consideration the intrinsic value of the asset, investors are aware of the underlying characteristics of the company and the unique characteristics of the asset. Hence, their investment decision making is conscious and they can make safer investments as they can check the fair value prices and the discount rate provided by analysts and portfolio managers.
On the other hand, because DCF valuation focuses on the intrinsic value it requires a lot of inputs and this facilitates the manipulation of the model to the best interest of portfolio managers, who would like to make some investments look more attractive.
b) Relative Valuation (multiples)
Relative valuation is based on the assumption that the value of an asset equals its market value. To do relative valuation, analysts use the prices of similar or comparable assets as variables to estimate the value of an asset and to control possible differences.
Relative valuation is based on two fundamental principles:
- The intrinsic value of an asset cannot be estimated by any valuation method. It is always equal to what the market is willing to pay for the asset depending on its unique characteristics.
- Markets are inefficient and assets are not priced perfectly, but because assets are comparable, errors in pricing can be identified and corrected more easily.
Because absolute market prices cannot be compared, they need to be converted into standardized values so that price multiples are created. Then, the multiples of the asset are compared to the multiples of the comparable asset to decide whether the asset is overvalued or undervalued.
The most common variables used to standardize market prices are earnings, book value, revenues and industry-specific variables. In particular, the multiples used are price to earnings ratio (P/E), price to book value (P/BV), and price to sales per share (P/S), but also value to EBIT, value to EBITDA and value to cash flow (earnings), and value to sales (revenues). Also what multiples will be used depends on the industry to be analyzed.
The main advantage of relative valuation is that it reflects market volatility, enabling investors to realize at any given moment if it is to their best interest to sell a stock or to invest building momentum. Besides, relative valuation provides portfolio managers with a variety of securities that are overvalued or undervalued, thus enabling them to build more diversified portfolios.
On the other hand, relative valuation leaves room for wrong judgment between overvalued and undervalued securities. Even if a security is found overvalued with relative valuation, it may still be undervalued compared to the market. This happens because relative valuation assumes that although markets are inefficient, errors in pricing can be identified and corrected more easily. However, this applies for the markets in the aggregate and not for individual securities. Also, the fact that relative valuation requires fewer inputs than DCF valuation implies that for any other variable the model makes implicit assumptions, which if proved wrong, the entire model is wrong.
In conclusion, there is no better or worse valuation model. Both DCF valuation and relative valuation serve their purposes effectively. The choice between the two is subject to the investment philosophy, the time horizon and the individual beliefs about the market.