Absolute valuation models calculate the present worth of businesses by forecasting their future income streams. The models use the information available in the financial statements and books of accounts of a company to arrive at its intrinsic or real worth. There are two types of absolute valuation models: Dividend Discount Model and Discounted Cash Flow Model.
The absolute valuation method is reductive as the analysis is focused on the characteristics of the company in isolation. There is no comparison to its competitors in the same industry or complementary sectors.
However, the process is problematic because competitive analysis is important to assess the overall market movement in a particular sector. Disruptive innovation due to new technology, major mergers and acquisitions, regulatory change, new market entrants, or bankruptcy may impact the trajectory of an entire sector.
Absolute valuation models calculate the present worth of businesses by forecasting their future income streams.
Valuation is used in corporate finance to calculate the fair market value or worth of a particular business, asset, or security.
There are two types of absolute valuation models: Dividend Discount Model and Discounted Cash Flow Model.
What is Valuation?
Valuation is used in corporate finance to calculate the fair market value or worth of a particular business, asset, or security. It is essential for potential investors to determine the fair market value of an asset or business. It includes various quantitative factors like capital structure and asset pool. Qualitative aspects, such as management style and leadership, may also be included.
Even though there is some degree of subjectivity, valuation is not a typical negotiation or auction, since that wouldn’t provide an accurate depiction of the company’s current value. Valuation can be undertaken for initial public offerings (IPO), mergers and acquisitions, stock option plans, tax liability computation, leveraged buyouts, and finance.
Valuation methodology can be broadly categorized into the following: (1) the Cost Approach, which evaluates the cost undertaken to build the company, (2) the Market Approach, which evaluates the relative value with respect to other players in the same sector, or (3) the Absolute Value Approach, which evaluates the intrinsic value of the company by analyzing its cash flows.
Types of Absolute Valuation Methods
1. Discounted Cash Flow Model (DCF)
Appropriate discount rates need to be calculated to arrive at the present value of the company, and the discount rate equals the rate of return for the investor. The Discounted Cash Flow model can be used for the valuation of anything that can affect cash flow, i.e., bonds, shares, an entire business, or a project within a business.
The DCF model uses a formula to calculate the rate of return of a business by evaluating anticipated payments and amounts receivable in the near future. The conclusion is a projected cash flow that can be used to predict how long the company can sustain a growth trajectory.
PV0 = Present value at time 0
CFn = Cash flow in period n
rn = Interest rate in period n
N = Number of periods
2. Dividend Discount Model (DDM)
According to the Dividend Discount Model, the future dividends generated by the securities of any company provide a fair representation of the intrinsic value of that business, once discounted to their present value. The DDM assumes that the future cash flows of a company are equal to dividends that are generated on its shares and consequently distributed to stakeholders.
The DDM method uses a fairly straight forward mathematical perspective to predict future dividend payments and the cost of equity share capital. However, the resulting valuation is far from accurate as the underlying assumption that dividend equals cash flow may not always be true.
PV0 = Present value at time 0
Dn= Cash flow in period n
rn= Interest rate in period n
N = Number of periods
Other Valuation Methods
The Cost-based Approach equates the cost of rebuilding a particular business from scratch to its current market value. It is not widely used in corporate finance because it ignores future value generation, which plays a key role in the valuation of a company. The absolute valuation method alone also discounts the importance of external market factors on the worth of a business.
Hence, the only way to minimize errors while valuating a business or security is to use a mixture of Absolute and Relative Value Analysis. It is because the intrinsic worth is better represented when compared to other companies. Investors look at the financial statements of competing companies to evaluate the degree of over or undervaluation of a particular company, and the comparable analysis approach is highly detailed and thorough.
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