What do both absolute and relative valuation aim to find? The company’s historic performance Future earning potential Fair market value
The correct answer and explanation is:
Correct Answer: Fair market value
Explanation:
Both absolute valuation and relative valuation methods aim to find the fair market value of a company or its stock. This is the estimated price at which a business or asset would change hands between a willing buyer and a willing seller, assuming both have reasonable knowledge of the relevant facts and are not under any compulsion to act.
Absolute Valuation:
Absolute valuation involves estimating a company’s intrinsic value based on fundamentals such as:
- Future cash flows
- Growth rates
- Discount rates
One of the most common absolute valuation models is the Discounted Cash Flow (DCF) method. It calculates the present value of expected future cash flows, helping investors determine what the company is really worth regardless of how the market values similar companies.
Example: If DCF analysis gives a company a value of $100 per share and it is trading at $80, the stock may be considered undervalued.
Relative Valuation:
Relative valuation, on the other hand, compares a company’s value to that of similar companies using financial metrics such as:
- Price-to-Earnings (P/E) ratio
- Price-to-Book (P/B) ratio
- Enterprise Value-to-EBITDA (EV/EBITDA)
The idea is to determine how a company is priced compared to its peers. If a company has a lower P/E ratio than others in the same industry, it may suggest the stock is undervalued.
Example: If similar companies trade at 15x earnings and your company trades at 10x, the market might be underpricing it.
Conclusion:
While they use different methods, both valuation approaches aim to estimate a fair market value—the price at which the asset should trade based on its fundamentals or comparisons. This value helps investors decide whether a stock is overvalued, undervalued, or fairly priced.