Question

compare the relative valuation and the discounted cash flow technique of valuation one will you prefer/ why?

Answer 1

In Relative valuation techniques the value of an asset is derived from the pricing of comparable or relative assets, standardized using a common variable such as earnings (P/E), cash flows (P/CF), book value (P/BV) or sales (P/S).

Discounted Cash Flow (DCF) Valuation estimates the intrinsic value of an asset/business based upon its fundamentals.Intrinsic Value of a business is the present value of the cash flows the company is expected to pay its shareholders. DCF Valuation is the basic foundation upon which all other valuation methodologies are built.

When we talk about preference in these two methods we find that both are complementary to each other as-

1. To perform Relative Valuation correctly, we need to understand the fundamentals of DFC Valuation. Similarly, to apply option pricing modelling techniques, we often need to begin with a discounted cashflow valuation.

2. Anyone who understands DCF technique will be able to analyze and apply all other valuation methodologies, thus underlying the importance of DCF Valuation.

On the basis of above findings we can conclude that ,DCF technique is better due to following causes-

1.DCF Valuation truly captures the underlying fundamental drivers of a business like-cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.

2.DCF relies on Free Cash Flows. To a larger extent, Free Cash Flows are a reliable measure that eliminate the subjective accounting policies and window dressing involved in reported earnings.

3.DCF model will tell how much the company’s stock is over-valued or under-valued, and also whether the current stock price is justified or not.

Thanks & all the best..............