I’ve read that price multiples are misleading unless you know the absolute valuation of its benchmark. Now when I think about doing DCF for the absolute valuation, I realized analysts may have the same assumptions except the forecasting period which may result to different intrinsic values.
How would you guys(equity analyst) remedy this? Did I misunderstand something?
I did not understand your question very well. Are you trying to compare DCF and relative valuation? One is based on long term, other is short term. One is based on your explicit assumptions about risk, growth and cash flows, the other (multiples) are based on how the company is priced based on comparables. If you are trying to find teh benchmark for your multiples, the benchmark would be the comparables but then you also have to adjust for the differences in the variables. for example PE ratio is a function of expected growth rate, risk and the payout ratio. You would like to select a stock thats cheap, that has higher growth, less risk and higher pay out ratio. I use regression to adjust the differences and get predicted PE and then make a conclusion if the stock is cheap or not.
Second, based on my experience, DCF gives you a range and not absolute value. The value varies based on several parameters that you get based on sensitivity analysis/simulation. Finally in DCF, what matters also is the supply and demand of your project. If your project has unique competitive advantages and has 4-5 companies bidding for your project, you have higher chances of getting what your assets are worth. If you have very few buyers, you are left to no choice but adjust your value based on buyer’s estimates. Not sure if answered your question but we can at least start the discussion
Given: Company A- PE ratio:19 Current value:10 Company B- PE ratio:20 Current value:30 How do I know Company A is undervalued or overvalued? I compare Company A’s PE to Company’s B’s PE. Company A is relatively undervalued compared to Company B. Assuming Company B’s instrinsic value is 60 or instrinsic range of 50 to 60. Company B would be absolutely undervalued. Therefore, I can conclude that Company A is also absolutely undervalued as it is relatively undervalued to Company B which is absolutely undervalued. However if Company B’s instrinsic rangeis 25 to 28. Company B would be absolutely overvalued, but I can’t say Company A is absolutely overvalued or undervalued. I conclude it is essential to resort to DCF. My problem with DCF is the forecasting period. However, I think I understand that the forecasting period is also part and derived from my assumptions from this guy - (http://www.analystforum.com/forums/investments/91347370)
I just want to clarify. You use regression on the historical PE ratios of the benchmark company to forecast future PE of the benchmark company? Please correct me if I am wrong.
I understand the relevance of competitive advantages for sustainable earnings and probably a longer forecasting period, but what do you mean by the supply and demand of your project in relation to DCF?
reg your first question, that was the point I was trying to make. Company A cannot be considered cheap in comparison to company B unless you control the variables that affect the PE ratios. As mentioned, PE depends on expected growth rate, risk an payout ratio, what if company A with low PE is riskier than company B or has low growth rate than company B, then you wont consider company A as cheap
Reg Question 2 : once you do regression, you get predicted PEs. You can the compare the predicted PEs with the trailing or current PEs ( the set of PEs that you use for regression) to see if its over valued or undervalued
Reg Q 3 : I meant that DCF gives you the intrinsic value : the value what the assets is worth which you may or may not get it. Lets say I develop an innovative technology. If my technology has superior competitive advantages and if I Value my technology to be worth 500 M USD ( DCF);Imagine i have tons of buyers in line to license my technology .Its a high possibility that I not only get 500 M ( what my assets are worth) but might be more because of too much demand from the buyers. Now, Imagine I have a technology which is a me too technology with very small comp advantage. There might be a possibility that I have only one buyer. In that case, I may not be able to negotiate hard and I may not get 500 M which I consider the intrinsic value of my technology. This is what I call the effect of supply and demand