What is an Absolute Value?
Absolute value, also called intrinsic value, refers to a form of business valuation that uses the Discounted Cash Flow (DCF) analysis to assess the financial value of a company. The method of absolute value differs from the relative value models that examine what a firm is worth compared to its competitors. Absolute value models aim to assess the intrinsic value of a product based on its expected cash flows.
Absolute Value Explained
Finding out if a stock is under- or overvalued is a primary value investor play. Value investors use common metrics, such as price-to-earnings ratio (P/E) and price-to-book ratio (P/B). It will determine whether a stock is to be purchased or sold based on its expected value.
In addition to using these formulas as a reference for valuation, the Discounted Cash Flow (DCF) valuation process is another way to assess absolute value.
Any future cash flows (CF) of a company is calculated using a DCF model and then discounted to the present value to determine an absolute value for the firm. The current value is known to be the firm's real worth or intrinsic value.
By comparing the share price of a company would be provided with its intrinsic value to the actual price of the stock, investors may assess if a stock is currently under- or over-valued.
Estimating the total worth of a company doesn't come without its setbacks. It is difficult to predict cash flows with total accuracy and to estimate how long cash flows will stay on a growth trajectory. In addition to estimating a specific growth rate, it can be difficult to determine a reasonable discount rate for calculating the present value.
Examples of methods employed under the DCF model include:
- Dividend discount model
- Discounted asset model
- Discounted residual income method
- Discounted FCF method
Many of these models include a return or discount rate used to discount a company's cash flows. These include dividends, earnings, operating cash flow (OCF), or free cash flow (FCF) to get the company's absolute value. The investor or analyst may use either the cost of equity or the weighted average cost of capital (WACC) as a discount rate depending on the approach used to conduct an assessment analysis.
Absolute Value vs Relative Value
Opposite of absolute value is a relative value. Although absolute value assesses an asset or company's inherent value without contrasting it to any other, relative value is on the value of similar assets or companies.
Analysts and investors use fair value analysis for stocks by looking at the financial statements and other multiples of the companies. In turn, they compare it to other similar firms to decide if those potential firms are over or undervalued.
