Introduction
Welcome back! In our last lesson, we established the fundamental principle of investing: the difference between a stock's market price and its underlying intrinsic value. We learned that an investor's goal is to buy a business for less than it's worth, using a margin of safety.
This lesson addresses the next logical question: how do we actually go about estimating that intrinsic value? There isn't one single way; instead, there are two major schools of thought. Today, we will distinguish between absolute valuation and relative valuation.
Understanding these two approaches is like learning the basic grammar of valuation. It will provide a mental framework for all the specific calculation techniques we'll cover in the upcoming lessons, starting with the most common valuation ratios like P/E.
The Two Paths to Valuation
When trying to determine what a company is worth, you can take one of two fundamental paths:
- Look inward: Analyze the company in isolation, focusing on its ability to generate cash in the future.
- Look outward: Compare the company to its peers to see how the market is pricing them.
These two paths are known as Absolute Valuation and Relative Valuation.
This flowchart gives a great high-level overview. We will be focusing on the Income Approach (Absolute/Intrinsic Value) and the Market Approach (Relative Value).
Let's break down each one.
1. Absolute Valuation: What Is It Worth on Its Own?
Absolute valuation seeks to determine an asset's intrinsic value based on its own fundamental characteristics, without referring to other companies. The core idea is that a company's value is the sum of all the cash it will produce for its owners over its lifetime.
Because you have a background in IT, you can think of this as a "white-box" analysis. You're looking inside the company's "code"—its financial statements and business model—to understand its internal logic and project its future performance (cash flows). The final output is a specific value, like LKR 150 per share, which represents your estimate of its true worth.
The most common absolute valuation methods are:
- Discounted Cash Flow (DCF): This involves forecasting a company's future cash flows and then "discounting" them back to what they are worth today.
- Dividend Discount Model (DDM): A simpler version of DCF that focuses only on the dividends a company is expected to pay out to shareholders.
To understand the concept of discounting future cash flows, let's watch a short explanation.
How to Value a Company | Best Valuation Methods
This video from Kenji Explains provides a clear, conceptual overview of the Discounted Cash Flow (DCF) model, which is the cornerstone of absolute valuation.
Watch from 04:42 to 06:41. Focus on the main idea: valuation is based on future cash flows, but that future money must be discounted to find its value in the present day. Don't worry about the formulas for now; just grasp the concept.
The key takeaway is that absolute valuation is an attempt to calculate a definitive number for what a business is worth based on its future economic output.
2. Relative Valuation: What Are Others Paying for Something Similar?
Relative valuation, in contrast, doesn't try to determine a standalone intrinsic value. Instead, it values a company by looking at the market prices of similar companies.
This is like valuing a house. You wouldn't typically build a complex financial model of its potential rental income. Instead, you'd look at the prices of similar houses that recently sold in the same neighborhood. In stock market terms, you compare a company's valuation "multiple" (like a P/E ratio) to the multiples of its industry peers.
This is more like a "black-box" comparison. You are comparing one company's price and key metrics to a benchmark set of other companies. If your target company is cheaper than its peers based on a key metric (e.g., it has a lower P/E ratio), it might be undervalued relative to the group.
Common relative valuation metrics (or "multiples") include:
- Price-to-Earnings (P/E) Ratio
- Price-to-Book (P/B) Ratio
This next video segment explains this comparative logic.
How to Value a Company | Best Valuation Methods
Here, Kenji Explains uses a simple analogy to describe the multiples-based (or relative) approach.
Watch from 01:20 to 03:35. Note how the process involves finding comparable companies and using an average multiple (in this case, the P/E ratio) to value the target company.
The core idea of relative valuation is to gauge whether a stock is cheap or expensive in relation to its peers or its own history.
Comparing the Approaches: Pros and Cons
Both methods aim to help you make better investment decisions, but they do so from different philosophical standpoints and have unique strengths and weaknesses.
To get a solid grasp of these differences, please read the following article. It does an excellent job of defining and comparing the two methods.
Relative Valuation vs. Intrinsic Valuation
This article from Financial Modeling Prep provides a comprehensive comparison of relative and intrinsic valuation.
Please read the following sections to solidify your understanding: Start with 'What is Relative Valuation?' and read through to the end of 'How Relative Valuation Works'. Then, read the section 'What is Intrinsic Valuation?'. Study the table under 'Comparing Relative and Intrinsic Valuation'. Read the sections 'Choosing the Right Valuation Approach' and 'Conclusion'. \nFocus on the different focuses, methodologies, and limitations of each approach.
Here's a summary table based on what you've learned:
| Aspect | Absolute Valuation (e.g., DCF, DDM) | Relative Valuation (e.g., P/E, P/B) |
|---|---|---|
| Core Question | "What is this business fundamentally worth?" | "What is the market paying for similar businesses?" |
| Focus | Inward-looking: company's own cash flows and growth prospects. | Outward-looking: market prices of comparable companies. |
| Pros | - Based on fundamentals, not market mood. - Forces detailed analysis. |
- Quick and easy to apply. - Captures current market sentiment. |
| Cons | - Complex and time-consuming. - Highly sensitive to assumptions. |
- Assumes the market is pricing peers correctly. - Hard to find truly comparable companies. |
As legendary investor Warren Buffett says, relative valuation metrics like P/E ratios are useful only as "clues" to the underlying business reality, which is what absolute valuation tries to capture directly.
Relevance to the Colombo Stock Exchange (CSE)
You might wonder if these are just academic concepts or if they are actively used for Sri Lankan stocks. The answer is: both are essential.
A guide for investors published by the CSE itself, titled "Stock Selection and Decision Making," introduces concepts from both schools of thought:
- Absolute Valuation: Section 11 of the document introduces the Dividend Discount Model (DDM), which is a classic absolute valuation method based on a company's future dividend payments.
- Relative Valuation: Section 15 introduces the Price Earnings (P/E) Ratio, and Section 16 discusses the Price to Book Value (P/BV) Ratio. These are the most widely used relative valuation metrics.
This shows that to be a thorough investor on the CSE, you need to understand how to value a company on its own merits (absolute) and how to compare it against its competitors (relative).
Conclusion
Great work today! You've now learned about the two main philosophical approaches analysts use to value a stock.
Key Takeaways:
- Absolute Valuation (e.g., DCF, DDM) is an inward-looking method that derives a company's value from its own projected future cash flows. It aims to find a specific intrinsic value.
- Relative Valuation (e.g., P/E, P/B ratios) is an outward-looking method that values a company by comparing it to similar companies in the market. It gauges if a stock is cheap or expensive compared to a benchmark.
- Absolute valuation is more fundamental but complex and assumption-driven. Relative valuation is simpler and market-based but can be misleading if the entire market is over- or undervalued.
- A robust investment analysis often uses both methods as a cross-check.
Preview of the Next Lesson:
Now that you have the high-level framework, we can start digging into the practical tools. In our next lesson, we will begin with the most popular and accessible valuation tools: calculating and interpreting key relative valuation ratios, specifically the Price-to-Earnings (P/E) and Price-to-Book (P/B) ratios.