Valuation
What Is Valuation?
As valuation expert Aswath Damodaran points out, “a postulate of sound investing is that an investor does not pay more for an asset than it is worth.”
This means that before buying or selling shares of a company, we need to estimate how much the shares are worth.
Two Types Of Valuation Techniques
The investor has the choice between two main valuation techniques:
- Intrinsic valuation
- Relative valuation
Intrinsic Valuation
Intrinsic valuation is about assigning an absolute dollar value to how much a company is worth, and comparing this amount to the firm’s share price.
Ultimately, the intrinsic value of a company is the sum of all of its future cash flows discounted back to today’s value using estimates for future growth rates and a discount rate.
A common approach to come up with an absolute amount is discounted cashflow analysis. Check out a detailed explanation of how this is done in this discounted cash flow (DCF) analysis article, as well as this DCF calculator, to learn more.
Relative Valuation
Relative valuation refers to estimating whether a company’s shares are cheap, fairly priced, or overpriced, not by determining an absolute dollar amount, but by comparing a company’s current financial ratios to (1) previous ratios, and (2) to competitor ratios.