Every asset or business has its value and valuation is done to find out that value. There are three approaches to valuation viz intrinsic valuation, relative valuation and contingent valuation. Because of these different approaches, value for a company can be different and the analyst or investor has to take a call on which value he will base his investment decision. Let us understand these approaches in brief before going further.
Intrinsic Value: The value of an asset is the present value of the expected cash flows. When we use discounted cash flow method to value a company, it is known as intrinsic valuation. Most of the valuations used by investors are not intrinsic valuations. Investors prefer to use relative valuations more than intrinsic valuation because of its simplicity and ease in use.
Relative Value: The value of an asset is what others are willing to pay for it. In other words, it is the value of asset based on how similar assets are priced in the market. When investors use multiple like P/E, P/S, P/BV and P/CF they are using relative valuations.
Contingent Value: The value of an asset may be contingent on what happens to other assets. This valuation approach is based on Option pricing model. For example, you are valuing a young biotech company, which has no revenues, no earnings and no cash flow to invest in its shares. Now you might ask that why should I value a company which has no profits and cash flow. Its because, this biotech company has a blockbuster drug in the FDA pipeline, if approved, will generate huge revenue and cash flow for the company.
When you buy the shares, you are actually buying an option. If that drug gets developed, it will produce lot of cash flow to the company but it is contingent on approval by FDA. Similar if you are buying shares in a company which has negative earnings and cash flow, you are buying an option based on contingent value. It is an option because if the company recovers from losses, you will make money.
After understanding these approaches, let us talk about what you can do when different valuation methods give you contradictory results. Investors use discounted cash flow valuation model and relative valuations to value a company and many times contradictory results come out. Discounted cash flow might suggest that the stock is undervalued and relative valuation may suggest that the stock is overvalued and vice versa. For an investor, what does it mean or what interpretation can be taken from these contradictory results?
When the stock is undervalued on discounted cash flow method and overvalued on relative valuation parameters, than it should be interpreted that the sector is undervalued relative to its fundamentals.
Intrinsic Value: The value of an asset is the present value of the expected cash flows. When we use discounted cash flow method to value a company, it is known as intrinsic valuation. Most of the valuations used by investors are not intrinsic valuations. Investors prefer to use relative valuations more than intrinsic valuation because of its simplicity and ease in use.
Relative Value: The value of an asset is what others are willing to pay for it. In other words, it is the value of asset based on how similar assets are priced in the market. When investors use multiple like P/E, P/S, P/BV and P/CF they are using relative valuations.
Contingent Value: The value of an asset may be contingent on what happens to other assets. This valuation approach is based on Option pricing model. For example, you are valuing a young biotech company, which has no revenues, no earnings and no cash flow to invest in its shares. Now you might ask that why should I value a company which has no profits and cash flow. Its because, this biotech company has a blockbuster drug in the FDA pipeline, if approved, will generate huge revenue and cash flow for the company.
When you buy the shares, you are actually buying an option. If that drug gets developed, it will produce lot of cash flow to the company but it is contingent on approval by FDA. Similar if you are buying shares in a company which has negative earnings and cash flow, you are buying an option based on contingent value. It is an option because if the company recovers from losses, you will make money.
After understanding these approaches, let us talk about what you can do when different valuation methods give you contradictory results. Investors use discounted cash flow valuation model and relative valuations to value a company and many times contradictory results come out. Discounted cash flow might suggest that the stock is undervalued and relative valuation may suggest that the stock is overvalued and vice versa. For an investor, what does it mean or what interpretation can be taken from these contradictory results?
When the stock is undervalued on discounted cash flow method and overvalued on relative valuation parameters, than it should be interpreted that the sector is undervalued relative to its fundamentals.
Similarly if a firm is overvalued on discounted cash flow method and undervalued on relative valuation, than it should be interpreted that sector is overvalued relative to its fundamentals.
What is the best option for an investor when contradictory results are given by both model? An investor should try to identify those companies which are undervalued on both the models. By this way, investors can benefit from market corrections.
While using relative valuation, investors should try to value a company relative to its sector as well as market. A firm can be undervalued relative to its sector but overvalued relative to the market, if the entire sector is mis-priced and vice versa.
About the Author
I am Prem, the founder of TheFinanceConcept. I am an Investment Advisor and a part-time blogger. I hold PG degree in MBA (Finance) and pursuing CFA. Blogging has become my passion from April 2011. I enjoy writing articles on Securities Analysis and Financial Planning.
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