Definition
The Absolute Valuation Formula refers to models or methods used to estimate the intrinsic value of an asset independent of its market value. These methods include the Discounted Cash Flow (DCF) analysis, dividend discount model, and residual income models. These formulas calculate an asset’s worth based on factors such as cash flows, dividends, and growth rates, as opposed to comparing it to other similar assets in the market.
Key Takeaways
- The Absolute Valuation Formula is a type of financial model that directly estimates a company’s intrinsic value based on its fundamentals, like cash flows, dividends, and earnings.
- This formula de-emphasizes relative or comparative worth. It instead focuses on present and expected future income, which are discounted to the present value, to calculate a company’s true financial value.
- Common absolute valuation models include the Dividend Discount Model (DDM), the Discounted Cash Flow (DCF) method, and the Residual Income Model. Each method focuses on a different aspect of the company’s financial reports for its valuation.
Importance
The Absolute Valuation Formula is a crucial finance term as it allows investors to determine the true or “intrinsic” value of an asset, such as a company, stock, or cash flow, independently of external factors and market prices.
This methodically assesses various factors like future earnings, dividend payback, and return on capital, providing a more comprehensive and precise assessment.
Its importance lies in offering a strong basis for investment decision-making, enabling investors to identify assets that could be under or overvalued in the market.
Consequently, this assists in making informed decisions that could maximize returns while minimizing risks.
Explanation
Absolute valuation formula is primarily used to calculate the true or “intrinsic” value of an asset or investment, regardless of its current market value. This approach involves examining the asset’s fundamental factors such as revenue, interest rates, profitability, growth potential, and risk profile among others.
The core purpose is to examine whether the asset or investment is undervalued or overvalued in the market based on its intrinsic value. If an asset’s intrinsic value is found to be higher than its current market price, it may be deemed as undervalued, and therefore, a potentially good investment; and vice versa.
The use of the absolute valuation method offers a detailed understanding of the asset or company being evaluated. It is most commonly used by financial analysts, investors, or portfolio managers to make investment decisions.
For instance, when it comes to stocks, the absolute valuation approach could involve methods such as Discounted Cash Flow (DCF) model or Dividend Discount Model (DDM), helping to inform decisions of buying, holding, or selling the stocks. While the actual values derived can differ based on the specifics of the model used, the underlying objective remains the same – to gauge the true worth of an asset, independent of its current market price.
Examples of Absolute Valuation Formula
Stock Analysis: In stock evaluation, analysts often use the absolute valuation formula to calculate the intrinsic value of a stock. For instance, say a company’s earnings per share is $5, the growth rate is 7%, and the desired rate of return is 10%. The absolute valuation formula known as Gordon Growth Model here can be used to find the intrinsic value of the stock [(5* (1+07))/(10-
07)].Property Valuation: In real estate, the absolute valuation formula can be applied to calculate the price of a property. This is done by determining the present value of the rental income it might generate in the future. If a property generates $20,000 rent per year with a 5% growth rate and discount rate of 7%, the value of the property can be calculated using the same Gordon Growth Model.Business Valuation: In the world of Mergers & Acquisitions, absolute valuation is used to evaluate the true worth of a business. For instance, if a business is projected to make a net cash flow of $500,000 next year, and is expected to grow at a rate of 3% annually, and it uses a discount rate of 7%, it could use the Discounted Cash Flow model (a kind of absolute valuation) to find out the valuation of the company today ([$500,000*(1+
03)]/(07-03)).
FAQs on Absolute Valuation Formula
1. What is an Absolute Valuation Formula?
Absolute Valuation Formula is used to estimate the intrinsic value of an asset based on its fundamentals and expected future cash flows. It does not consider the market value of the asset.
2. What are the types of Absolute Valuation Formulas?
Primarily, there are three types of Absolute Valuation Formulas common in finance. They include the Dividend Discount Model (DDM), the Discounted Cash Flow model (DCF), and the Residual Income Model.
3. When is Absolute Valuation Formula used?
Absolute Valuation Formula is usually used when assessing the value of assets with predictable and stable cash flows. For instance, it is often used in valuing large, mature companies in stable industries.
4. What are the limitations of Absolute Valuation Formula?
The estimates derived from Absolute Valuation Formulas are only as accurate as the input values. Hence, any inaccuracies in estimations of the components like future cash flows, growth rates, and discount rates can significantly affect the valuation. It also assumes that the chosen parameters will remain constant over the valuation period, which might not always be the case.
5. How does Absolute Valuation Formula differ from relative valuation?
Absolute Valuation calculates the ‘true’ value of an asset based on its fundamentals while relative valuation involves comparing the asset’s value to other similar assets in the market. While absolute valuation can be more accurate given the right inputs, relative valuation often provides a more straightforward, less input-intensive approach to valuation.
Related Entrepreneurship Terms
- Discounted Cash Flow (DCF)
- Free Cash Flow (FCF)
- Net Present Value (NPV)
- Cost of Capital
- Internal Rate of Return (IRR)
Sources for More Information
- Investopedia: A comprehensive online resource dedicated to investing and personal finance education.
- Coursera: An online learning platform offering courses in various disciplines such as finance.
- Khan Academy: An online learning platform that offers a comprehensive range of free instructional courses, including finance and capital markets.
- Corporate Finance Institute (CFI): A provider of online professional certification programs and courses in fields like financial analysis, investment banking, and more.
