1. Focus of this Course
An intrinsic valuation means that we look at the company in relative isolation.
In other words, we aren't really looking or worried about what the company's
peers are worth, instead what we do is forecast the future performance of
the business, calculate its future cash flows and discount them back to
today, to get the company's values. As you can see, this form evaluation
really only looks internally at the company. We make assumptions about what
the future of the company will look like.
The DCF requires a little more art versus science, so it's usually more
challenging than a relative valuation. One other important thing regarding
a DCF, a DCF doesn't directly depend on the mood of the market,
since we are almost solely focused on the fundamentals of the company,
irrespective of what is going on in the market.
Now, let's take a look at relative valuation.
With this approach, we look at what other companies are worth
and use them as a proxy for what we're trying to value.
As mentioned, there are two commonly used relative valuation methodologies.
The first method is to look at comparable companies or peers that are
publicly traded, they're relatively easy to find because these companies
shares are publicly traded on a stock exchange, so we can see their
price at any time, and then we can determine what other investors are
willing to pay for that company. If the peers are similar to what
we're trying to value, then we can use multiples to figure out what
the company we're trying to value is actually worth. For example,
we can use the price to earnings or P/E multiple.
This relates a company's market cap to its net income.
If we can find good comparable companies, we can take the average or
median P/E multiple and apply that multiple to the entire company's net
income to figure out its equity value. This valuation
is more likely to reflect the mood of the market
and produce evaluation that is closer to the market price than a DCF
valuation. Although this is a bit of a generalization, it is not always
true. The other main relative valuation approach is to look at precedent
transactions. Precedent transactions mean past mergers and acquisitions,
where we can see how much an acquiring company paid for a business.
This form of valuation includes a takeover premium. Because generally, more
money is paid for a controlling position in the acquired company.
Taken together, these two forms of market valuation can provide a good overview
of what a company might be worth relative to other companies.
2. Let's practice!