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Saw quite a number of news stories which talk about valuation, so hope to share a bit on this
Relative Valuation - estimates the value of an asset by looking at the pricing of assets relative to a common variable like earnings, cash flows, book value or sales.
• Most common multiples: P/E, EV/EBITDA, Price/Book Value, EV/Sales, PEG ratio, free cash flow yield, dividend yield
Case: In 2020, the average P/E ratio of the S&P 500 index was around 22x, while the historical average is about 15x. This suggested that the market might have been overvalued at that time.
• Historical analysis: how does current pricing compare to history
Quant: In 2007, just before the financial crisis, the P/E ratio of the S&P 500 index was around 18x, which was higher than its historical average, indicating that the market was overvalued.
• Comparable analysis: how does current pricing compare to similar assets
Case: In 2020, Apple Inc. had a P/E ratio of 33x, while Microsoft Corp. had a P/E ratio of 34x. Considering both companies operate in similar industries and have comparable business models, their valuations seemed fairly aligned.
• Returns-based analysis: how does current valuation compare when returns are taken into consideration
Quant: In 2020, Company A had a P/E ratio of 25x and an expected annual return of 7%, while Company B had a P/E ratio of 15x and an expected annual return of 10%. Based on these metrics, Company B appeared to be a more attractive investment, given its lower valuation and higher expected return.
Intrinsic Valuation - relates the value of an asset to the present value of expected future cash flows on that asset.
• DCF, dividend discount model
Case: Using the DCF model, an investor estimates that the intrinsic value of Company X's stock is $100 per share, while its current market price is $90 per share. This suggests that the stock may be undervalued.
• Which one should you use? It's about checks and balances, but some techniques are better under certain circumstances.
Usage
relative valuation is often preferred when comparing companies within the same industry, as it accounts for industry-specific factors. In contrast, intrinsic valuation methods like DCF are more suitable for companies with stable cash flows and predictable growth rates, such as utility companies or well-established consumer goods firms.
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Great ariticle, would you like to share it?
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