Intro to Finance: Valuation - Relative vs. Intrinsic Valuation

What This Is

Relative valuation and intrinsic valuation are two fundamental approaches in finance used to estimate the value of a company or asset. Relative valuation compares the subject company's multiples (e.g., P/E, P/B) to those of similar companies, while intrinsic valuation estimates the company's value based on its underlying fundamentals (e.g., cash flows, growth rates). For example, consider Apple (AAPL) with a market capitalization of $2 trillion and a P/E ratio of 25. Using relative valuation, we might compare AAPL's P/E to that of its peers, such as Microsoft (MSFT) or Alphabet (GOOGL). However, intrinsic valuation would require estimating Apple's future cash flows and discounting them to their present value.

Key Formulas & Symbols

• P/E Ratio = Market Price / Earnings Per Share where P/E Ratio = price-to-earnings ratio, Market Price = current stock price, Earnings Per Share = net income / number of shares outstanding.
• P/B Ratio = Market Price / Book Value Per Share where P/B Ratio = price-to-book ratio, Market Price = current stock price, Book Value Per Share = total equity / number of shares outstanding.
• DCF =? (CFt / (1 + r)^t) where DCF = discounted cash flow, CFt = cash flow at time t, r = discount rate, t = time period.
• WACC = (E / (D + E)) * R_d * (D / (D + E)) + (E / (D + E)) * R_e where WACC = weighted average cost of capital, E = market value of equity, D = market value of debt, R_d = cost of debt, R_e = cost of equity.
• g = (Earnings Growth Rate) where g = growth rate, Earnings Growth Rate = historical or projected earnings growth rate.
• r = (Cost of Equity) where r = cost of equity, Cost of Equity = required return on equity, typically estimated using the CAPM.
• CAPM = R_f +-* (R_m - R_f) where CAPM = capital asset pricing model, R_f = risk-free rate,-= beta, R_m = market return.
• IRR = NPV / Initial Investment where IRR = internal rate of return, NPV = net present value, Initial Investment = initial investment amount.

Step-by-Step Calculation

1. Relative Valuation: Calculate the subject company's multiples (e.g., P/E, P/B) and compare them to those of similar companies.
2. Intrinsic Valuation: Estimate the company's future cash flows using a DCF model, assuming a constant growth rate (g) and a terminal value (TV).
3. WACC Calculation: Calculate the weighted average cost of capital (WACC) using the market values of equity and debt, and the respective costs of debt and equity.
4. DCF Calculation: Calculate the discounted cash flow (DCF) using the estimated cash flows, discount rate, and time periods.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market values to reflect the current market conditions and avoid overestimating the company's value.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate at which the NPV equals zero, while NPV ranking is the ranking of projects based on their NPV.
• Mistake: Ignoring the terminal value in a DCF model.
• Correction: Include the terminal value to reflect the company's future growth and avoid underestimating its value.

Exam / CFA Tips

• Tip: Be prepared to calculate WACC using different scenarios (e.g., different debt-to-equity ratios).
• Tip: Understand the differences between relative and intrinsic valuation, and when to use each approach.
• Tip: Be able to estimate the cost of equity using the CAPM, and calculate the IRR and NPV of a project.

Quick Practice Problem

Problem: Calculate the free cash flow to the firm (FCFF) for Tesla (TSLA) using the following data: Earnings Before Interest and Taxes (EBIT) = $10 billion, Depreciation and Amortization (D&A) = $2 billion, Capital Expenditures (CapEx) = $5 billion, Change in Working Capital (?WC) = $1 billion.

Answer: FCFF = EBIT + Depreciation - CapEx - ?WC = $10 billion + $2 billion - $5 billion - $1 billion = $6 billion.

Last-Minute Cram Sheet

• The dividend discount model (DDM) requires g < r – otherwise the model explodes.
• The P/E ratio is sensitive to changes in earnings growth rates.
• WACC is a weighted average of the costs of debt and equity.
• The CAPM is a widely used model to estimate the cost of equity.
• IRR is the rate at which the NPV equals zero.
• NPV ranking is the ranking of projects based on their NPV.
• The terminal value is an estimate of the company's future value.
• The DCF model assumes a constant growth rate.
• The WACC calculation requires market values of equity and debt.