Absolute value meaning
Business valuations are important in a multitude of ways. They not only help investors understand a company’s worth but also help a business chart plans for the future. Valuations can also be incredibly significant in guiding a business to refocus and drive growth.
For those of you who find yourself thinking what absolute value is, it is a method of business valuation that is based on Discounted Cash Flow (DCF) analysis to appraise a company’s financial worth. The DCF analysis model determines the value of a company based on its future estimated cash flows, by leveraging the information from a company’s book of accounts and financial statements. It is an invaluable tool to understand the value of and return on investments in the future in relation to a company’s current cost. Absolute value is also known as intrinsic value. The absolute value method of determining a business’s value stands in contrast to the relative value method that calculates a company’s worth as compared to its competitors. This means that absolute value can be determined and used for comparisons with companies beyond a said business’s domain as well.
The absolute value method can be used to determine the value of investments and get insights about a company’s health. In addition, investors use it to determine the actual value of stocks and whether they are overvalued or undervalued. This is significant in determining whether a stock should be bought, held, or sold.
Absolute values and value investing
Absolute values are essential and crucial to value investors. These are investors in the stock market who follow a strategy of choosing stocks in the market that seem to be trading lower than their intrinsic, or absolute, value. Typically, value investors utilise other metrics to evaluate their investments like the price-to-book ratio (P/B) and the price-to-earnings ratio (P/E), along with the intrinsic value and discounted cash flow analysis, to make decisions in the stock market.
Now that we have a clearer idea of how absolute value can be significant for investors, let us take a closer look at the different models to calculate absolute value through the discounted cash flow analysis method.
Methods to calculate absolute value
Under the discounted cash flow analysis model, there are several methods to calculate the absolute value of a company and the value of investments. These include:
- Dividend discount method
- Discounted asset method
- Discounted residual income model
- Discounted FCF model
- Let us discuss each model one by one.
Dividend discount method
The dividend discount method is used to estimate or predict the cost of a company’s stock. Its basic assumption is that a company’s current price is the sum of the entirety of the future dividend payouts that are discounted to the present value. Under this method, there are other assumptions as well. For example, it also assumes that the dividend growth rate will stay constant, forever. Thus, it can be understood that it is better suited for bigger and more mature businesses, which have a robust history of regular dividend payouts.
The benefit of this model is that it is a way to calculate the ‘correct’ value of a stock, regardless of the then-present market conditions. The observation is simple, if the value derived is greater than the current market price, it indicates that the stock is undervalued.
Discounted asset method
In the discounted asset method, the goal is to establish and understand the relationship between the return on investment of a stock and the risk in the investment, in relation to the market. It is a way to measure risk and is extensively used to evaluate expected returns on assets. It is a model that seeks to validate the expectations of investors, looking for compensation for the risk and the time value of money. This method calculates the value of a stock using both the expected return on the market and a risk-free asset and also takes into account the given asset’s sensitivity to the forces of the market.
Discounted residual income model
The discounted residual income model is widely used by industry experts to figure out the return on investments and the absolute value of a business. While residual income may simply seem like profits of a company or excess cash, it actually refers to the income of a firm that remains after the actual cost of capital is accounted for, i.e. cost of equity. The method is used to estimate a company’s future earnings and compensate for equity costs to evaluate a business accurately. While this method can be useful to understand what is the absolute value of firms that do not pay dividends, it is heavily dependent on future approximations of a given company’s finances. This makes it vulnerable to a variety of factors like biases or misrepresentation on financial and accounting books, among others.
Discounted FCF model
FCF refers to free cash flows. Simply put, it is the cash generated by a company after the cash requirements for operations and capital asset maintenance are accounted for. This can be used to pay shareholders and creditors. Free cash flow can directly be used to calculate profits and is an insight into the health of a business. The advantage of this model is that it is able to take into account multiple fundamentals of running a business like the equity cost, and growth rate, among others.
What is common in all the methods above is that they all require a discount rate or rate of returns to compute a business’ cash flow and derive the absolute value. Two metrics used as a discount rate in the models above (varies from one to another) are the weighted average cost of capital and the cost of equity.
Conclusion
Understanding absolute value meaning is immensely significant for both investors and businesses. Absolute value, or intrinsic value, is a method to determine a company's true value based on its projected cash flows. It is also used to assess returns on stock investments and make crucial decisions in the market. By employing various models under the discounted cash flow analysis, investors can make well-informed decisions regarding stock valuation and potential investments. Equipped with a solid understanding of absolute value, investors gain the ability to navigate the intricacies of the stock market, evaluate businesses, and make sound investment decisions.
