Different valuation models are used to estimate true intrinsic value of a company.
Absolute valuation models are based on fundamentals approach. This is DCF method, dividend discount model, asset based model and residual income model.
Valuation methods based on relative models are a lot easier and quicker.
They are based off of the law of one price, which determines that two similar assets should have similar prices.
As for me this is an approach that very often ends with wrong conclusion about stock’s price.
Comparable methods are good for preliminary filtering of securities so you don’t need to spend your time by analyzing all of them.
Just figure out which stocks are the best and start analyzing those individually using absolute valuation models.
Comparison doesn’t provide the final price rather it gives an idea whether the stock is cheap or expansive compared to the benchmark stocks.
You need to understand fundamental reasons and factors that create shareholder value, i.e. fundamental methods are a must!
But all of them use different approaches in terms of what is forecasted.
Technical analysis along with fundamental approach is an additional advantage. You can use bullish technical models if you think there is enough fundamental margin safety.
DCF model was presented in my article with a practical example.
A second practical model is a residual income model.
It focuses on operating and investment activities and representing net income less a charge for common shareholders’ opportunity cost in generating net income.
While interest expense on the income statement only accounts for a firm’s cost of its debt, the model takes care about the cost of equity that was used to generate net income. The cost of equity can be represented as an opportunity cost or the required rate of return. Isn’t it the same as ROA?
The intuitive explanation is very simple. Let’s say you have $1 000 000. You want a return of 5% p.a. on this capital.
If a company you invested in provides net income $50 000 per annum than a residual income model shows the difference between these two figures, i.e. the value of zero.
So from shareholder’s perspective this is a minimum return required to compensate for the equity cost.
With other words, a positive residual income indicates that a company has met shareholder’s expectation.
A negative residual income indicates a company is depleting shareholder wealth.
Residual income approach takes into account book value of a company and the present values of its expected future residual incomes.
The model offers both positives and negatives when compared to the more often used dividend discount and DCF methods but requires forecasting Net operating profit after tax (NOPAT) and Net operating assets (NOA) values. DCF and dividend models require forecasting other values, such as free cash flow and future dividends. For practical reasons horizon period forecasts and a terminal period forecast used in these models otherwise all of the models would yield identical estimates when the expected payoffs are forecasted for an infinite horizon.
So which model yields better results? May be NOPAT is easier to forecast compared to DCF and dividends because the latter numbers are derived based on NOPAT figures.
Return on investment (ROI) is another metric which measures return in relative terms.
Taking into account that return on assets (ROA) is often referred to as ROI we see they both provide a reasonable assessment of profitability estimation in relative values while the residual income model provides absolute values.