Absolute valuation models: Meaning, Criticisms & Real-World Uses

What Are Absolute Valuation Models?

Absolute valuation models are a set of financial modeling techniques used to determine the intrinsic value of an asset, most commonly a company's stock, by estimating its expected future cash flows and then discounting them back to the present. Unlike relative valuation models, which compare an asset to similar assets in the market, absolute valuation models seek to calculate a value based solely on the asset's inherent characteristics and future prospects. These models are a core component of financial modeling and investment analysis, widely employed in corporate finance to make informed investment decisions. The central premise behind absolute valuation models is the concept of the time value of money, asserting that a dollar received in the future is worth less than a dollar received today.

History and Origin

The foundational principles behind absolute valuation models, particularly the idea of discounting future returns to estimate present value, have a long history. Early forms of discounted cash flow analysis were used in the British coal industry as far back as 1801 to evaluate mining projects.⁴ The more formal theoretical framework for modern absolute valuation models, especially as applied to equities, was significantly developed in the 20th century. Notably, John Burr Williams, in his 1938 text The Theory of Investment Value, formally articulated the Discounted Cash Flow (DCF) method, which remains a cornerstone of absolute valuation. This approach gained wider acceptance in financial economics during the 1960s and became increasingly utilized in U.S. courts for valuation purposes in the 1980s and 1990s. The development of detailed financial statements and computational tools further propelled the adoption and sophistication of these models.

Key Takeaways

Absolute valuation models determine an asset's intrinsic value based on its expected future cash flows.
They rely on discounting future values back to the present, accounting for the time value of money and risk.
The Discounted Cash Flow (DCF) model and the Dividend Discount Model (DDM) are primary examples of absolute valuation models.
These models provide a theoretical or fundamental valuation, which can then be compared to market prices.
Estimating future cash flows and determining the appropriate discount rate are critical and often complex aspects of applying absolute valuation models.

Formula and Calculation

The most prominent absolute valuation model is the Discounted Cash Flow (DCF) model. It calculates the Net present value (NPV) of a company's projected free cash flows to the firm (FCFF) or free cash flows to equity (FCFE), plus a terminal value representing the value of cash flows beyond the explicit forecast period.

The general formula for a DCF valuation is:

\text{Value} = \sum_{t=1}^{n} \frac{\text{CF}_t}{(1+r)^t} + \frac{\text{TV}}{(1+r)^n}

Where:

(\text{CF}_t) = Cash flow in period (t)
(r) = The discount rate (often the cost of capital, such as Weighted Average Cost of Capital, or WACC)
(n) = The number of periods in the explicit forecast horizon
(\text{TV}) = The terminal value at the end of the forecast horizon

Free cash flow (FCF) is typically calculated as:

\text{FCF} = \text{Net Income} + \text{Non-cash Charges} - \text{Capital Expenditures} - \text{Change in Working Capital}

Capital expenditures represent funds used by a company to acquire, upgrade, and maintain physical assets.

The Terminal Value ((\text{TV})) is often calculated using a perpetuity growth model:

\text{TV} = \frac{\text{CF}_{n+1}}{(r-g)}

Where:

(\text{CF}_{n+1}) = Cash flow in the first year after the explicit forecast period
(g) = Perpetual growth rate of cash flows

Interpreting Absolute Valuation Models

Interpreting the output of absolute valuation models involves understanding the calculated intrinsic value in relation to the current market price of an asset. If an absolute valuation model calculates an intrinsic value higher than the asset's current market share price, it may suggest the asset is undervalued. Conversely, if the intrinsic value is lower, the asset might be overvalued. The accuracy of this interpretation heavily relies on the quality of the inputs, particularly the projected future cash flows and the chosen discount rate. Analysts use these models to form an independent opinion on what an asset is truly worth, detached from market sentiment or comparative analyses. This fundamental assessment provides a benchmark against which market prices can be evaluated, aiding investors in identifying potential investment opportunities or risks.

Hypothetical Example

Consider a hypothetical company, "InnovateTech Inc.," that an analyst is evaluating using a DCF model, an absolute valuation model.

Scenario: InnovateTech is a rapidly growing software company. The analyst projects its free cash flows for the next five years and estimates a terminal value thereafter.

Assumptions:

Projected Free Cash Flows (FCF):
- Year 1: $10 million
- Year 2: $12 million
- Year 3: $15 million
- Year 4: $18 million
- Year 5: $20 million
Discount rate (WACC): 10%
Perpetual Growth Rate after Year 5: 3%

Calculation Steps:

Discount each year's FCF to present value:
- Year 1: ($10 \text{M} / (1 + 0.10)^1 = $9.09 \text{M})
- Year 2: ($12 \text{M} / (1 + 0.10)^2 = $9.92 \text{M})
- Year 3: ($15 \text{M} / (1 + 0.10)^3 = $11.27 \text{M})
- Year 4: ($18 \text{M} / (1 + 0.10)^4 = $12.29 \text{M})
- Year 5: ($20 \text{M} / (1 + 0.10)^5 = $12.42 \text{M})
Calculate Terminal Value (TV) at the end of Year 5:
- FCF in Year 6 = ($20 \text{M} \times (1 + 0.03) = $20.60 \text{M})
- (\text{TV} = \frac{$20.60 \text{M}}{(0.10 - 0.03)} = \frac{$20.60 \text{M}}{0.07} = $294.29 \text{M})
Discount Terminal Value to Present Value:
- (\text{PV of TV} = $294.29 \text{M} / (1 + 0.10)^5 = $182.72 \text{M})
Sum Present Values to get Intrinsic Value:
- ($9.09 \text{M} + $9.92 \text{M} + $11.27 \text{M} + $12.29 \text{M} + $12.42 \text{M} + $182.72 \text{M} = $237.71 \text{M})

Based on these projections, the absolute valuation models suggest InnovateTech Inc. has an intrinsic value of approximately $237.71 million. This figure would then be compared to the company's current market capitalization to assess its relative attractiveness as an investment.

Practical Applications

Absolute valuation models are extensively used across various segments of the financial industry. In investment banking, these models, especially Discounted cash flow analysis, are fundamental for advising clients on mergers and acquisitions, initial public offerings (IPOs), and other corporate transactions. They provide an objective basis for determining the value of a target company or a business unit, forming a key part of the due diligence process.³

Beyond transaction advisory, absolute valuation models are crucial for portfolio managers and equity analysts who seek to identify undervalued or overvalued securities. By deriving an intrinsic value for a company, analysts can make buy, sell, or hold recommendations based on a fundamental assessment rather than market momentum.

Furthermore, these models play a vital role in regulatory contexts, particularly when determining the fair value of illiquid or hard-to-value assets. For example, the U.S. Securities and Exchange Commission (SEC) provides guidance on how investment companies should determine the fair value of investments for which market quotations are not readily available, often necessitating the use of methodologies akin to absolute valuation models.² This ensures that reported asset values reflect a good faith determination, even in the absence of active market prices.

Limitations and Criticisms

While powerful, absolute valuation models are subject to several limitations and criticisms. A primary concern is their reliance on numerous assumptions, particularly regarding future cash flows and the discount rate or cost of capital. Small changes in these inputs can lead to significant variations in the calculated intrinsic value. For instance, an analyst's projection of a company's long-term growth rate or its future capital expenditures can be highly subjective and difficult to forecast accurately over extended periods.

Another significant challenge arises when valuing assets with unpredictable or negative future cash flows, such as early-stage startups or companies in distressed industries. In such cases, the traditional application of these absolute valuation models may yield unreliable results. The estimation of terminal value, which often accounts for a substantial portion of the total valuation, is particularly sensitive to the chosen perpetual growth rate and discount rate assumptions.

Moreover, the process of determining fair value for assets, especially those with unobservable inputs (often categorized as "Level 3" under accounting standards), presents considerable challenges. Such valuations may rely heavily on management estimates and internal models, increasing the potential for subjective bias and reducing verifiability. This can lead to discrepancies between estimated and realized market values, as highlighted in reports discussing the complexities of valuing certain financial instruments.¹ The complexity and input-sensitivity mean that absolute valuation models require considerable expertise and judgment to apply effectively.

Absolute Valuation Models vs. Relative Valuation Models

Absolute valuation models and relative valuation models represent two distinct approaches to valuing assets, particularly companies. The fundamental difference lies in their methodology and the type of value they aim to determine.

Absolute Valuation Models focus on an asset's inherent or intrinsic value. They achieve this by projecting the asset's future cash flows and discounting them back to the present using an appropriate discount rate. Examples include the Discounted cash flow (DCF) model and the Dividend Discount Model (DDM). The resulting value is theoretically independent of current market sentiment or the pricing of comparable assets.

Relative Valuation Models, conversely, estimate an asset's value by comparing it to similar assets that have observable market prices. These models typically use valuation multiples derived from publicly traded companies or recent transactions, such as Price-to-Earnings (P/E), Enterprise Value/EBITDA, or Price-to-Book. The underlying assumption is that similar assets should trade at similar multiples. While relative valuation provides a quick and market-driven assessment, it doesn't necessarily indicate an asset's true fundamental worth but rather its value relative to its peers. Confusion can arise because both aim to arrive at a value, but their foundational assumptions and interpretation of "value" differ significantly. Absolute models provide a theoretical anchor, while relative models offer a market-based perspective.

FAQs

What is the primary goal of absolute valuation models?

The primary goal of absolute valuation models is to determine the intrinsic value of an asset, which is its inherent worth based on its ability to generate future cash flows. This value is independent of current market prices or comparable assets.

What are the most common absolute valuation models?

The most common absolute valuation models are the Discounted cash flow (DCF) model, which values a company based on its projected free cash flows, and the Dividend Discount Model (DDM), which values a stock based on the present value of its expected future dividends.

Why is the discount rate important in absolute valuation models?

The discount rate is crucial because it accounts for both the time value of money and the risk associated with receiving future cash flows. A higher discount rate will result in a lower present value, reflecting greater risk or a higher required rate of return for the investment.

Can absolute valuation models be used for all types of companies?

While absolute valuation models are versatile, they are most effective for companies with predictable and positive future cash flows. They can be challenging to apply accurately to early-stage companies, those with volatile earnings, or those in industries undergoing significant disruption, as forecasting cash flows becomes highly speculative.

How do absolute valuation models help investors make decisions?

Absolute valuation models provide investors with a fundamental baseline for an asset's worth. By comparing this calculated intrinsic value to the current market price, investors can identify potential opportunities where an asset may be trading below its fundamental value, suggesting it is undervalued, or avoid assets trading above their fundamental value, indicating they might be overvalued.