A relative valuation is simpler to understand and easier to present to clients and customers than a discounted cash flow valuation. A relative valuation is much more likely to reflect the current mood of the market, since it is an attempt to measure relative and not intrinsic value.
However, some general guidelines to consider are using DCF to estimate intrinsic value based on cash flows and risk if reliable data is available; relative valuation to estimate market value based on performance and quality if a sufficient set of comparable assets is available; and using both methods to cross-check ...
As a result, the DCF is often referred to a two-stage valuation model, as opposed to the CCF which is a single-stage model. The DCF method can be utilized when a company's future growth trend is projected to be non-linear, such as growth at 20% in year 1, 15% in year 2 and 5% in year 3.
The most theoretically sound stock valuation method, is called "income valuation" or the discounted cash flow (DCF) method. It is widely applied in all areas of finance. Perhaps the most common fundamental methodology is the P/E ratio (Price to Earnings Ratio).
In discounted cash flow valuation, the objective is to find the value of an asset, given its cash flow, growth and risk characteristics. In relative valuation, the objective is to value an asset, based upon how similar assets are currently priced by the market.
Discounted Cash Flows
This technique is highlighted in Leading with Finance as the gold standard of valuation. Discounted cash flow analysis is the process of estimating the value of a company or investment based on the money, or cash flows, it's expected to generate in the future.
Key Uses of the Market Approach
When there is a need for you to defend the valuation of your business before the tax authorities or in a legal dispute. When you want to justify the value of your business when there is a dispute such as a buyout or partner disagreements.
Company Stage and Industry: DCF may be suitable for stable, mature companies with predictable cash flows, while Comparable Companies Analysis may be apt for industries with multiple comparable companies.
Discounted Cash Flow (DCF) Analysis
💡 Best For: Businesses with stable and predictable cash flows.
Relative valuation models are used to value companies by comparing them to other businesses based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E ratios. The logic is that if similar companies are worth 10x earnings, then the company that's being valued should also be worth 10x its earnings.
Disadvantages. DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won't be accurate.
There are three primary approaches under which most valuation methods sit, which include the income approach, market approach, and asset-based approach. The income approach estimates value based on future earnings, using techniques like the discounted cash flow analysis.
In summary, the advantages of relative valuation include its ability to reflect current market conditions, reliance on observable data, and relative simplicity.
Relative value is a method of determining an asset's worth that takes into account the value of similar assets. This is in contrast with absolute value, which looks only at an asset's intrinsic value and does not compare it to other assets.
Relative valuation also does not provide a clear target price or a margin of safety for the company, as it depends on the market prices of the comparables. For example, a company may have a high P/E ratio because it is overvalued by the market, or because it has high growth potential or low risk.
The main Pros of a DCF model are:
Extremely detailed. Includes all major assumptions about the business. Determines the “intrinsic” value of a business. Does not require any comparable companies.
We do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech start-up) or when debt and working capital serve a fundamentally different role.
The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset.
Discounted Cash Flow Valuation
DCF (Discounted Cash Flow) can provide an accurate assessment of probable future business earnings. DCF estimates the company's value based on the future or projected cash flow. This is a good method to use because sometimes the business will be worth more than you think.
Market Approach
The value of a business can be evaluated by comparing all the businesses operating with the same scale in the same industry or region. After establishing a peer group of comparable companies, ratios such as EV/EBITDA, EV/Revenue, P/E ratio can be calculated.
The Highest and Best Use (HBU) Analysis is a comprehensive evaluation aimed at identifying the most optimal use of vacant land or land considered vacant. This analysis focuses on four key criteria: physical possibility, legal permissibility, financial feasibility, and maximum productivity.
Therefore, income-based valuations are most reliable for businesses with stable, predictable cash flows. As previously noted, the income approach can be combined with the cost approach, which will allow the direct valuation of tangible assets and indirect valuation of intangible assets.
Because it involves comparing a company to similar companies or the overall market, making the process more relatable.