Forecasting Company Performance: Absolute Valuation Models

When a world-renowned chef creates a fantastic dish, the recipe is crucial to success, but so are the ingredients and the equipment. In the same way, which valuation model an analyst uses to evaluate a stock is crucial for success. Why do you think the valuation model matters?

Exactly!

No. Clearly, different companies will have different characteristics.

So you work through the valuation process. The second step mixes in the forecast data (ingredients), and the third step uses a valuation model (equipment and techniques) to compute the stock's value. First you'd use either a top-down or bottom-up approach to forecast company performance. Where do you think a top-down approach starts with a company like Samsung?

No. Inventory costs are company specific, so they are part of a bottom-up approach.

That's right! A top-down analysis will start with international and national economies, then work into more Samsung-specific forecasts. For a bottom-up analysis, the opposite is true. You'd start with company-specific figures, such as sales per retail square foot, and work into a full sales forecast. But don't forget to also account for qualitative factors, such as the integrity of company management and the quality of accounting practices.

Not quite. Industry trends are part of both a top-down and bottom-up approach but do not start either analysis.

So after all the work is done building a forecast, you can use various valuation models to estimate the value of a company and its common stock. To start, you can choose between two branches of valuation models. An __absolute valuation model__ is a model that specifies an asset's intrinsic value. A __relative valuation model__ estimates an asset's value relative to that of another asset. But since most investors are concerned with intrinsic value, absolute valuation models are typically used because the value generated captures all related returns from holding the company.

What do you think the present value consists of?

Not quite. Dividends may be only a part of the return from an asset.

No, actually. Interest refers to a bond investment. Present value models compute equity valuations.

Yes! Discounted future cash flows derive the value of common stock as the present or discounted value of its expected future cash flows. Note that these cash flows include dividends because dividends are a discretionary distribution. If dividends are paid, you can use the dividend discount model, which is based on cash flows at the shareholder level.

But in most cases, it's best to focus on company-level cash flows. The two main absolute valuation models used are free cash flow and residual income. For free cash flow, the model can be broken into __free cash flow to the firm__ (gross of payments to debt holders) and __free cash flow to equity__ (net of payments to debt holders). Then the two models discount future cash flows back to the present using a discount rate.

But how do equity present value approaches differ from valuing bonds? In general, they're pretty similar, but equity usually involves more uncertainty. Why do you think that's the case?

Not quite. Cash flows are hard to estimate and involve business, financial, and technology factors.

You got it! The discount rate is estimated, where a bond valuation discount rate can be based on observable market interest rates. The other big difference is in the estimation of cash flows, which are not a contractual obligation like bond interest. So analysts must factor in these differences when comparing bonds and stock valuation methods and also consider calculating a range of intrinsic values to better gauge overall value.

No. Equity cash flows would not have a maturity date, but bond holdings would.

Other absolute valuation models include __residual income__ and __asset values__. A __residual income model__ is based upon accrual accounting earnings in excess of the opportunity cost of generating those earnings. Another absolute valuation technique is __asset-based valuation__, which values a company on the basis of the market value of the assets or resources it controls.

To summarize: [[summary]]

The purpose of the valuation can vary

Each stock will have the same characteristics

Inventory costs

Industry trends

International and national economics

Interest only

Dividends only

Discounted future cash flows

Cash flows are easily defined

The discount rate is estimated

Cash flows have a maturity date

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