Question

Which is better intrinsic or relative valuation? Why?

Answer 1

Intrinsic value (True value) can be found out by discounting the future cashflows on the asset. If some one can predict the actual future cash flows, we can find the true value by discounting them using the require rate of return. Few models in this method are dividend discount model, free cash flow model. If we know the dividend payouts and coupon paymnets for the future for shares and bonds respectively, can be valued using this method. In the same way, investors can value a company if they can predit the future free cashflows.

Relative valuation model is used if wants to value an asset by using its benchmark. For example, if an index P/E is 15x, one of the company in the index has an P/E of 10x. Then we say that the company is under valued in comparision to the benchmark. In this model, we assume that the peer's (similar assets) are correctly valued in the market, hence we can use these assets to value our asset. Best example is a real estate asset. If some one sells a flat in an apartment of 1,500 sq.ft at $500,000, if others want to sell their flat in the same apartment they can use this as a benchmark to value.

If anyone can correctly predict the future cashflows, intrinsic value is appropriate. If not or less liquid assets like real estate assets,relative valuation can be used.