Finally, in some instances / sectors, there are certain
absolute valuation metrics that make sense, and that often only change slowly over time.
However, there are few limitations of
using absolute valuation as you will require to make few assumptions and the results are only as good as inputs.
I try to keep cash levels based on risks associated with the
current absolute valuation multiples as well as my assessment of sustainability of current margins.
The first includes
absolute valuation models that directly estimate expected returns by using an approximation of discounted cash flows condensed into a building - block type of model, such as the Gordon growth model.2 The second category includes relative valuation models based on price multiples that are compared against a steady - state level.
, b) plays a role, but only within the 10 % stretch band, c) matters, but one can always find a portfolio's worth of
low absolute valuation stuff (if one doesn't worry about the implied adverse selection bias that when everything else is pricey, the cheap stuff is much more likely to be cheap for a good reason), or d) something else?
Investors who understood the reality of
absolute valuation knew it had become a near mathematical impossibility for equities to generate satisfactory returns going forward until the excess valuation had either burned off or stock prices had collapsed to bring them back in line with fundamentals.
«I'm basically doing time arbitrage - finding companies where economic, industry or company - specific disappointments prompt short - term investors to sell me their shares at
compelling absolute valuations based on what I consider normal longer - term earnings power» Whitney George
Returning to asset managers, % of AUM is the
key absolute valuation metric, and I believe Price / Sales (based on operating profit margins) is the best stock specific valuation ratio.
The following charts illustrate how an absolute return investor might have fared had he chosen to move out of stocks and into cash where the
real absolute valuation of the stock market ended the prior month below a certain threshold.
Relative Valuation Models The two
absolute valuation models work well when yields remain constant, but in the real world prices can vary wildly around slower - moving fundamentals, such as dividends and earnings.
The standard refrain from mutual fund managers and institutional investors goes something like this: our clients already made the asset allocation decision to invest in equities, so now it is our job to be fully invested and find the best of what is currently available, regardless of
absolute valuation levels.
But frankly speaking, this is an over-simplified way of seeing whether the stock market is over-valued or not, and I'm not even done with talking
about absolute valuation nor begun to talk about relative valuation.
It's ordinarily better to
use absolute valuations of the individual securities one is buying, but that is now complicated by the fact that the «risk free» rate is now so low that any almost valuation is justifiable in a DCF.
[Essentially, GARP still needs to be anchored in terms
of absolute valuations — rather than relative valuations, which is just another version of the greater fool].
Analysts determine intrinsic value using either
absolute valuation or relative valuation models, and some use both.
Goldman Sachs» Neil Mehta believes ConocoPhillips (NYSE: COP) offers «compelling relative and
absolute valuation, especially given share price underperformance in 2016.»
The following chart highlights the extent of growth stocks»
absolute valuation on a «price - to - book» basis.
I will say this, though:
absolute valuation can be an excuse for investors that are not willing to do the digging necessary to unearth more complex values.
Neither the price - to - earnings (P / E) expansion in the chart above nor
the absolute valuation levels are sustainable.
Relative valuation of stocks is a good alternative to
the absolute valuation.
Nevertheless, this post is not focused on
the absolute valuation and we'll discuss more in another post where you will require to understand a lot of complex terms like future free cash flow projections, discount rate (weighted average cost of capital - WACC) etc to find the estimated present value.
The absolute valuation tries to determine the intrinsic value of the company based on the estimated free cash flows discounted to their present value.
All values are relative, of course, but I prefer to stick with the low
absolute valuations one can find in Germany.
Absolute Valuation Models We begin with a discussion of the two absolute valuation models named in Table 1: Model 1, the average of dividend yield and earnings yield; and Model 2, dividend yield plus historical average real growth.
The absolute valuation metrics, which incorporate dividend yield and earnings growth, also lead to a positive, but scant, forecast of around 3.5 % after inflation.
Earnings growth, a key component in
the absolute valuation models we have described, is also an important consideration in relative valuation models.
The Cambria Global Value Index applies a similar valuation methodology across 45 markets and seeks outperformance by selecting markets based on relative and
absolute valuation.
As it turns out,
our absolute valuation discipline produced a satisfactory result, even during periods when the market did not.
This might arise from another stock specific, relative or
an absolute valuation metric / approach they've chosen.