Question

What are two different approaches to equity/stock valuation? Discuss each approach in detail with pros and cons and applicability.

Answer 1

Two different approaches of equity valuation are absolute method and relative pricing method.

1. Absolute Method= this method of equity valuation is intended at finding out the value of firm through its own analysis rather than looking at the industry so absolute method will be always depending upon the cash flows which are being generated by the company or dividend which are being generated by the company so absolute method are company-specific in nature and they are not related to other companies.

Absolute method will be including all the methods like discounting cash flow method and dividend discounting method which will be used in order to find out the intrinsic value of the company and then carrying out the analysis about the company is undervalued or overvalued according to the intrinsic value and then investing into the share according to the discrepancy between the price and the value.

This type of valuation method can only be suitable for companies which are just company specific in nature and this will not be taking any macro factors and industrial factories in discounting so they are not that used in determination of overall systematic risk.

Benefits related to this method is that this method is a direct method and this will be providing out the value of the company which will be company specific in nature and they will not be deriving estimates about industry.

2. Relative Valuation method= relative valuation methods are those methods which are used to find the value of the company by comparing it to the industry and valuing it according to the standard of the industry.

Popular type of relative valuation method will be price to earning method in which the price to earning multiples of industries taken and it is accordingly discounted into the share price of the company and it can also be leading to other analysis method like enterprise value to EBITDA and these are the methods which will be useful in order to find out the relative valuation of the company in respect to the industry and find out whether the company is overvalued or undervalued according to the industry standard.

these methods of relative valuation are helpful in order to determine the outside factors and they will be helpful in order to find the value of the company in relation to the industry standard because company is always performing according to industrial norms

The problem is this method is that not every company is able to discount itself according to the industry standard because there are certain leaders and certainly laggards in the industry so when valuation should be done accordingly rather than providing a similar Multiples factor to every company.