What is the Difference Between Relative and DCF Valuation?

Introduction

Relative and DCF valuation are two of the most popular ways of evaluating the value of a company's stock. While both approaches have the same goal of yielding an approximation of the stock's value, they do so in very different ways. Understanding the differences between Relative and DCF valuation can help you make more informed investment decisions in the stock market.

Definition of Relative and DCF Valuation

Relative valuation is a method of estimating a company's value by comparing it to other similar companies in the market. This approach leverages the public information available about other companies in order to calculate an approximate value for the target company. DCF (Discounted Cash Flow) valuation is a method of estimating a company's value by projecting its future cash flows and discounting them to present value. This approach relies on economic variables such as interest rates and income tax and utilizes a company's own performance metrics in order to make accurate assessments of its future performance.

Overview of the Differences

• Relative Valuation
  • Uses public information
  • Uses metrics such as Price-to-Earnings or Price-to-Sales to evaluate differences in stock price
  • Deals with current performance
  
  
• DCF Valuation
  • Utilizes economic variables
  • Uses metrics such as Free Cash Flow to measure future performance
  • Deals with future performance
  
  

DCF Valuation

DCF valuation is a way to evaluate the fair value of a company based on forecasting future cash flows. It is also referred to as discounted cash flow valuation. This approach is used to calculate the present value of cash flows generated in future by the company. It takes into account the value of money today and future risks that could affect the cash flow of the company.

Types of DCF Valuation

There are two types of DCF valuation methods that are used to calculate the future cash flow of a company. The first method is the Multiplier Method. This method uses a multiplier such as the Price-to-Earnings ratio to estimate the future cash flows. The second method is the Discounted Cash Flow Model. This model takes into account the present value of future cash flows by discounting them at the appropriate discount rate.

Pros and Cons of DCF Valuation

• Pros:
  • The DCF valuation approach is an objective method for valuation as it takes into account the future cash flow of the company.
  • It takes into account both the present value of money and future risks.
  
  
• Cons:
  • The DCF valuation approach is based on estimates and therefore may not be accurate.
  • It is a complex approach as it involves multiple calculations to estimate the future cash flows.
  
  

Relative Valuation

Relative valuation is an investment technique used to analyze and compare the cost of different securities, mostly stocks. It converts these values into a single figure, and expresses the security’s cost in relation to the value of other securities in the same asset class. Comparative figures, such as price-to-earnings and price-to-book ratios are typically used to make this comparison.

What is Relative Valuation?

Relative valuation is a method of valuing a security by comparing it to similar securities, or comparable companies, in the same asset class. The security’s cost is measured in relation to the cost of similar securities in order to help determine the security’s value.

Types of Relative Valuation

Relative valuation typically relies on one of three ratios: price-to-earnings (P/E) ratio, price-to-book (P/B) ratio and enterprise value-to-earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) ratio. These ratios provide insight into a company’s profitability, financial health and future earnings potential.

Pros and Cons of Relative Valuation

Relative valuation offers investors several advantages. It is easy to use, as investors can rely on publicly available financial data in order to make comparison. It is also very cost-effective, since it does not require any additional financial research or analysis. On the other hand, relative valuation has some major shortfalls. Since it is based on past performance, it does not consider expected future performance, making it an unreliable measure of value.

• Pros:
  • Easy to use
  • Cost-effective
  
  
• Cons:
  • Does not consider future performance
  • Unreliable measure of value
  
  

Comparing DCF and Relative Valuation

Relative and Discounted Cash Flow (DCF) valuation represent two distinct methods for assessing the value of a business or asset. Relative valuation approaches compare a subject company’s current performance, characteristics, and metrics to similar companies for valuation purposes. In contrast to relative approaches, DCF valuation uses projected future cash flows and discounts them to present value in order to determine the net present value of an investment. Each type of valuation analysis has advantages, and it can be difficult to determine which approach should be used in an event of valuation.

The Differences between the Two Types of Valuation

Relative valuation uses external markets data as inputs and compares the subject company to peers, or companies within the same sector. Relative approaches are relatively faster and less expensive than DCF and can give an overall impression of the company’s potential value. The primary output of a relative valuation is a range of values which the company could be said to be worth. In contrast, DCF approaches take time and effort to get an accurate result, as they require inputting detailed financial information that goes into the model to determine the future cash flows.

Factors to Consider When Determining Which Type to Use

When choosing between a DCF and relative valuation, the investor should consider a number of factors. Time and resources available to valuate the subject company is an important criteria, often dictating the best approach to use. In addition, the investor should consider the purpose of the valuation and the company’s stage in its life cycle, as either approach can offer advantages in certain circumstances. Further, the investor must consider the amount of quality data available on the subject company, as well as the quality of data available for comparison companies.

Given the differences between relative and DCF valuation and the various factors that should be considered when making a decision, it is important to consider which type of valuation is best suited to a given situation. Regardless of the approach taken, it is imperative to understand both relative and DCF valuation in order to accurately gauge the value of a business or asset.

Financing for Relative Valuation

The two main methods of accounting for financing in Relative Valuation are technical analysis and long-term outlook. Financing plays an important role when making an assessment of the value of an entity because it helps an investor make projections on the return of the investment. Through a combination of technical analysis and long-term outlook, an investor can determine the amount of financing that should be applied to the Relative Valuation.

Technical Analysis

Technical analysis includes studying the markets and its price movements, which can help investors find companies with financial positions that may be undervalued. It is important to use the technical analysis to better assess the risks associated with the investment and to determine a fair market value. Technical analysis can provide an investor with an insight into short-term performance and the current expectations for the company's future performance.

Long-Term Outlook

Long-term outlook involves looking at the company's future potential and the amount of debt it has taken on. Investors must consider the company's underlying assets, past debt performance, as well as the expectations for the company moving forward. When taking on debt, investors must also include the expected return on investment, along with other costs such as interest payments, in order to determine the amount of financing that should be applied to the Relative Valuation.

Investors must be aware of the risk profile of any company they are investing in. The amount of financing will vary depending on the risk associated with the company and an investor must be comfortable with the amount of financing that is applied to the Relative Valuation. Both technical analysis and long-term outlook provide investors with a better understanding of how to assess the value of an entity, enabling them to make an informed decision on the amount of funding required for the evaluation.

Resource

Companies may use either a relative or discounted cash flow (DCF) valuation method to determine the value of a business. While both methods are widely used, they have different advantages and disadvantages. Understanding the fundamental differences between the two methods and having access to resources related to each type of valuation can help investors and financial analysts make more informed decisions.

Publications

Many publications focus on the theories and practices of financial valuation. An example of such a publication is 'Valuation: Measuring and Managing the Value of Companies' by McKinsey & Company. This book is widely used in both business school and corporate settings and offers a comprehensive overview of the various forms of valuation, from relative to DCF.

Websites

Websites are an invaluable resource in understanding DCF and relative valuation. Investopedia and Seeking Alpha are two of the most popular websites for learning about financial valuation techniques. Both websites feature daily articles that discuss the various financial instruments, strategies and techniques. These websites also offer interactive tutorials and quizzes to help in the understanding of relative and DCF valuation.

Applications

There are numerous financial and investment applications available that can assist in the understanding of DCF and relative valuation. For example, the Bloomberg terminal is a popular tool used by wall street investors. The Bloomberg terminal provides up-to-date market data, real-time news and financial analysis tools that can help investors better understand and predict the value of companies. There are also numerous other financial and investment applications available, such as the Stocks App and Robinhood, that can give investors insight into the relative and DCF valuation methods.

Conclusion

Relative and DCF valuations are two of the most common methods used to arrive at an appraised value of a business or equity. Relative valuations involve comparing the company being valued to similar companies and capitalizing related metrics. DCF valuation involves the maximization of future cash flow. Each of these methods has advantages and disadvantages and a business or investor must choose the one most appropriate for the particular situation. While neither method is perfect, they can help to inform a more defensible, well-reasoned approach to valuation.