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Absolute value
What is the absolute value?
Absolute value, also known as intrinsic value, refers to a business valuation method that uses discounted cash flow analysis (DCF) to determine the financial value of a business. The absolute value method differs from relative value models which examine the value of a business relative to its competitors. Absolute value models seek to determine the intrinsic value of a business based on expected cash flows.
KEY REFERENCES
Absolute value refers to a business valuation method that uses discounted cash flow analysis to determine the financial value of a business.
Investors can determine whether a stock is currently undervalued or overvalued by comparing the stock price of a company that is expected to have its absolute value with the current stock price.
There are challenges in using absolute value analysis, including forecasting cash flows, forecasting accurate growth rates, and evaluating appropriate discount rates.
Unlike the relative value, the absolute value does not require comparison between companies in the same sector or sector.
Understanding Absolute Values
Finding out whether a stock is undervalued or overvalued is a primary game for value investors. Value investors use popular metrics such as price-to-earnings ratio (P / E) and price-to-book ratio (P / B) to determine whether to buy or sell a stock based on of its appraised value. In addition to using these reports as a valuation guide, another way to determine absolute value is discounted cash flow (DCF) valuation analysis.
Some form of future cash flow (FC) for a business is estimated with a DCF model and then discounted to determine an absolute value for the business. The current value is considered the true value or the intrinsic value of the company.
Absolute value vs. relative value
The relative value is the opposite of the absolute value. While absolute value examines the intrinsic value of an asset or business without comparing it to someone else, relative value is based on the value of similar assets or businesses. Analysts and investors who use relative value analysis of stocks examine the financial statements and other multiples of the companies they are interested in and compare them to other similar companies to determine whether those potential companies are overvalued or undervalued. . For example, an investor will look at the variables – market capitalization, income, sales numbers, P / E ratios, etc. – for companies like Amazon, Target and/or Costco if he wants to know the relative value of Walmart.
The Challenges of Using Absolute Value
Estimating the absolute value of a business is not without its downsides. It is difficult to predict cash flow with absolute certainty and predict how long cash flow will remain on a growth trajectory. In addition to predicting an accurate growth rate, it can be difficult to estimate an appropriate discount rate to calculate present value.
Since the absolute valuation approach to determine the value of a share is strictly based on the characteristics and fundamentals of the company under analysis, no comparison is made with other companies in the same sector or the same industry.
But companies in the same industry should be considered when analyzing a company from moving activity in the market – bankruptcy, government regulatory changes, disruptive innovations, employee layoffs, mergers and purchases, etc. – in each of these companies, it can affect how the whole industry evolves. Therefore, the best way to assess the true value of a stock is to incorporate a combination of absolute and relative valuation methods.
