Question

Link why – and how - absolute and relative valuation tools are combined when discerning intrinsic value.  How do you calculate a relative P/E metric value from history?  What are the conceptual and practical objectives of multiple measures in determining a valuation range?

Answer 1

Absolute value / Fundamental value - Is the scientific way to determine what is the actual true value of an enterprise or stock as on date, considering the future, past and present.

There are several methods to compute absolute value , and some of them include the DCF method, intrinsic value method, Liquidation value, market valuation methods etc, and the application of the same would depend on the investor, the goals of the investor, and the type of asset being measured.

Relative value - Is a analysis based tool, where the stock is benchmarked against stocks with a market value in the market, and trying to identify the relative value of the pegged asset vs a benchmarked asset. Hence, relative valuation does not take into account any fundamental value propositions of the stock in hand, and has more to do with the relative worth of the stock vs stocks in the market.

Both are essential tools to determine value, since fundamental value, gives the future value of the stock in cash flow terms, however, relative value takes into account the investor sentiment, and when some sectors are given more benefit and some sectors are penalized, due to various factors, and that sentiment is also taken into account.

PE metric from history:

1. Identify the historic trend in EPS

2. Identify the historical trend in market prices of the stock

3. Ensure the time frame for both of the above, as the same

4. Average History Price / Average historic EPS = Average historical PE multiple

Why multiple measures to determine valuation range :

1. Though the dcf is a well accepted way to determine the value of a stock, there are some pitfalls in using the DCF. Factors and variables such as the discount rate used, and the projections given by the company, are highly susceptible to error, and are not the most objective measures.

2. Book value and other real value methods, takes into value the present , and gives a Real concrete value, not marred by projections, estimations , or data that isnt written in stone.

3. Historical value , and historical trends, provide insights into how the company has progressed, what is its standing vs competition, and what is the industry advantage or disadvantage it is carrying.

Considering factors such as the above, each method would give you a different fair value for the stock. When the purpose is general determination of fair price, a combination of factors need to be taken into account to give you a range of values, since share value is never an objective truth, more of an estimated value.