Course 301: Valuing Stocks
Absolute, or Intrinsic, Valuation
In this course
1 Introduction
2 What Is a Stock's Value?
3 Common Valuation Ratios
4 Relative Valuation
5 Absolute, or Intrinsic, Valuation

The second basic method of valuing stocks uses absolute, or intrinsic, value. Usually, absolute value is estimated by calculating the present value of the company's future free-cash flows (cash flow minus capital spending). The present value of that future-income stream is the theoretically correct value of the stock. This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools. Calculating the absolute value of a stock isn't easy. It's tough to forecast how fast a company's free cash flows will grow, how long they'll grow, and at what rate they should be discounted back to the present. At Morningstar, we estimate stocks' absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model. The result is an analyst-driven estimate of a stock's fair value in absolute terms.

In an imperfect world, opting for the much easier--if less pure--method of relative valuation often makes sense. However, when the companies you're using as your benchmark are themselves mispriced, relative valuation can lead you astray; without a reliable measurement tool, your measurements will be off. That last point can be crucial. If the S&P 500, for example, is trading at a P/E ratio that is very high by historical standards, using it as a benchmark can be hazardous. A stock can appear much cheaper than the overall market and still be quite expensive in absolute terms. So what's an investor to do? Unfortunately, there aren't any easy answers. The best way to approach stock valuation is by using many different methods, the same way you would if you were valuing a used car or a house. Checking out what similar houses in a neighborhood have sold for is akin to relative valuation, and walking through a house you're interested in--looking at the construction and quality of materials--is similar to intrinsic valuation. A judicious mix of both methods will serve you well.

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