An absolute valuation model aims to determine the intrinsic or "true" worth of an asset, such as a company, by forecasting its future income streams and discounting them back to their present value.
In essence, these models try to answer the question: "Based on its fundamentals, what should this asset be worth?" Unlike relative valuation, which compares a company to its peers, absolute valuation focuses solely on the company's own financial performance and prospects.
Here's a more detailed breakdown:
How Absolute Valuation Models Work
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Forecasting Future Income: The core of any absolute valuation model involves projecting the future earnings, cash flows, or dividends that the asset is expected to generate. This typically involves analyzing historical financial statements, industry trends, and management's guidance.
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Discounting to Present Value: Future income is worth less than income received today due to the time value of money (i.e., money can earn interest over time). Therefore, the projected future income streams are discounted back to their present value using an appropriate discount rate. This discount rate represents the required rate of return an investor demands for taking on the risk of investing in the asset.
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Summation of Present Values: The present values of all the projected future income streams are added together to arrive at the estimated intrinsic value of the asset.
Types of Absolute Valuation Models
Several common absolute valuation models exist, including:
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Discounted Cash Flow (DCF) Models: These models project a company's future free cash flows (the cash available to the company after all expenses and investments) and discount them back to their present value. A common approach is the Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE) model.
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Dividend Discount Models (DDM): These models focus on the dividends a company is expected to pay out to shareholders. The present value of these future dividends is calculated to determine the intrinsic value of the stock. These are best suited for companies with a consistent dividend payout history.
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Residual Income Models: This model values a company by adding its book value of equity to the present value of its expected future residual income (earnings less a charge for the cost of equity).
Advantages of Absolute Valuation
- Intrinsic Value Determination: It provides an estimate of intrinsic value, independent of market sentiment.
- Long-Term Perspective: It encourages a long-term investment horizon, focusing on fundamental business drivers.
Disadvantages of Absolute Valuation
- Sensitivity to Assumptions: The valuation is highly sensitive to the assumptions made about future growth rates, discount rates, and other factors. Small changes in these assumptions can lead to significant changes in the estimated intrinsic value.
- Complexity: These models can be complex and require a deep understanding of financial statements and valuation techniques.
- Data Dependency: Accuracy depends on the quality and reliability of the financial data used.
Example
Imagine valuing a company using a DCF model. You project its free cash flow for the next five years and estimate a terminal value (the value of all cash flows beyond the projection period). Then, you discount each year's free cash flow and the terminal value back to the present using an appropriate discount rate (e.g., the company's weighted average cost of capital). The sum of these present values represents the estimated intrinsic value of the company.
In conclusion, absolute valuation models are a powerful tool for assessing the intrinsic value of an asset by forecasting future income streams and discounting them to their present value. However, it's crucial to acknowledge the inherent limitations and sensitivity to assumptions when using these models.
