Two major approaches for valuing a company are the intrinsic valuation and the relative valuation. The relative valuation is the more frequently used method. It estimates the value of an asset by merely looking at the market values of common variables of comparable companies or looking at the company’s own historical valuations. Variables that are examined include earnings, cash flows, book value, or sales. For example, if you were using the relative valuation method to value Apple, you might compare its stock’s price/earnings ratio (P/E ratio) with Microsoft’s P/E ratio. If Apple has a P/E ratio of 25 and Microsoft has a P/E ratio of 20, then Apple’s shares are more expensive on a relative basis (a higher P/E ratio means that investors are paying more so the stock is more expensive compared to one with a lower P/E ratio).
On the other hand, the intrinsic approach is determined using a discounted cash flow, with the value of the asset being the present value of expected future free cash flows (cash flow minus capital spending) on that asset. This valuation is based on the asset’s intrinsic characteristics, such as its ability to generate cash flows.
In simple terms, valuing a lemonade stand using the intrinsic approach suggests that its value should fundamentally equal the present value of future cash flows that the stand is expected to generate. Using the relative approach, you may determine the value of the lemonade stand by simply looking at the value of comparable lemonade stands.
However, there are disadvantage to both methods. A disadvantage to the relative valuation method is that not all companies are alike and comparable. The intrinsic approach is less frequently used because calculating the intrinsic value of a stock is tough. For example, it is hard to forecast how fast and how long a company’s free cash flows will grow. In the end, do your research well and consider using multiple stock valuation methods.
