Absolute & Relative Valuation Models: What You Need To Know

How do you know if a company is overvalued, undervalued or fairly valued? Investors face this question daily, and the answer lies in valuation models.

Understanding the different types (absolute vs relative) and their purpose is crucial to sound investment decisions. Though the two approaches estimate a company’s value, they reflect fundamentally different philosophies on how it is defined and calculated.

What Are Valuation Models?

Valuation models are tools for estimating a company’s value, i.e., what it is worth and how much to pay for its shares today. They are essential in corporate finance, equity research, investment banking and portfolio management. 

Models fall into one of these two categories based on how they estimate a company’s value.

• Absolute valuation models
• Relative valuation models

Each category has its strengths, limitations and use cases. Let’s dive in.

Absolute Valuation: The Intrinsic Value Approach

Absolute (or intrinsic) valuation models estimate a company’s value based on its underlying fundamentals. These models seek to answer the question:

“What is a company worth based on its ability to generate future free cash flows and/or dividends?”

Rather than relying on the value of similar companies, absolute valuation models attempt to calculate what a company should be trading at based on its estimated future value if markets were perfectly rational.

In other words, if a company’s future cash flows are worth £300 per share today, its stock should be trading around £300 if markets were perfectly rational.

Absolute valuation models take a bottom-up (company-based) approach to estimating value. They offer a more grounded and internally consistent view of a company, which is especially important when market prices deviate from fundamentals.

Common Absolute Valuation Models

1. Discounted Cash Flow (DCF) Model – Forecasts future cash flows and discounts them to their present value using an appropriate discount rate.
2. Dividend Discount Model (DDM) – Values a company based on its expected future dividends.

Relative Valuation: The Market-Based Approach

Relative valuation models determine a company’s value by comparing it to similar companies or recently completed mergers and acquisitions (M&A). Valuation multiples like PE and EV/EBITDA and the prices paid in past deals are used to derive value. 

Rather than asking, “What is this company worth on its own?”, relative valuation asks:

“What are similar companies worth, and how does this one compare?”

Relative valuation models are grounded in the belief that comparable companies should trade at similar valuations under efficient market conditions. In other words, if a company’s peers are worth £40 billion, the company being valued should be worth something close to that.

Common Relative Valuation Models

1. Comparable Companies Analysis (Trading Comps) – Values a company using the market multiples of its peers.
2. Precedent Transactions Analysis (M&A Comps) – Analyses the prices paid in past M&A deals of similar firms to derive a company’s value.

Absolute & Relative Valuation Models: The Differences Summarised

Absolute and relative valuation models have some similarities. They estimate a company’s value, use historical financial data and rely on investor judgements and assumptions.

But it’s the differences that set them apart. Here’s a breakdown.

Approach

• Absolute valuation models are company-based and depend on internal financial performance.
• Relative valuation models are market-based and depend on external comparisons.

Ease of Use & Speed

• Absolute valuation models are more technical and take some time to build.
• Relative valuation models are easier and quicker to build and use. 

Primary Inputs

• Absolute valuation models rely predominantly on growth rate assumptions and discount rates.
• Relative valuation models require the valuation multiples of a company’s peers and the prices paid in past mergers and acquisitions.

Market Price Dependency

• Absolute valuation models are independent of market prices.
• Relative valuation models rely heavily on the market’s pricing of comparable firms.

Model Outcomes

• Absolute valuation models estimate a single figure for a company’s value.
• Relative valuation models give a range of values based on the valuation multiples used.

Despite the differences, using absolute and relative valuation models together gives a more complete view of a company’s valuation.

Absolute & Relative Valuation Models: Strengths & Limitations

From their differences to their respective pros and cons.

Absolute Valuation Models – Strengths

• Fundamentally Driven – Valuation is based on a company’s ability to generate future cash flows and/or dividends, not other companies.
• Long-Term Focused – They encourage deep company analysis as investors and analysts usually forecast ten years of free cash flows and/or dividends.
• Independent of Market Irrationality – Because valuation is company-based, model outcomes aren’t affected by overvaluation (investor optimism) or undervaluation (investor pessimism).

Absolute Valuation Models – Limitations

• Assumption-Sensitive – Small changes in assumptions, especially in the discount rate, can dramatically alter the valuation outcome.
• Data-Intensive – Valuation requires several years of historical company data, which can be time-consuming to retrieve without a spreadsheet plugin.
• Terminal Value Dominance – Since terminal value accounts for a large percentage of a company’s value, overly optimistic assumptions can skew the valuation outcome.
• Young/Fast-Growing Companies – Companies with unstable cash flows and dividends are difficult to value. 

Relative Valuation Models – Strengths

• Market-Relevant – Valuations reflect the market’s consensus of companies in particular sectors and industries.
• Reflects Industry Norms – These models anchor your analysis in the cycles and averages of an industry.
• Useful for Cross-Checks – The range of values from relative valuation models supplements the single figure from absolute valuation models.

Relative Valuation Models – Limitations

• “Comparable” Isn’t Always Comparable – Peers may differ significantly in risk, growth, size and market positioning.
• Market Noise Prone – Valuation multiples can be distorted by market hype, investor sentiment or economic shifts.
• Valuation Ignores Intrinsic Drivers – It doesn’t account for unique company strengths and strategies.
• Backwards Looking – Valuation is often based on historical earnings and past transactions, which may not reflect future potential.

When To Use Each Approach

Choosing between absolute and relative valuation models depends on several factors. Some are summarised below.

This is just a rough guide, as there are exceptions. For example, some analysts still use a DCF (absolute valuation model) for negative cash flow companies. It’s not impossible to use it, but valuation becomes more challenging, and uncertainty is amplified.

Modelling Best Practice

In practice, investors and analysts use both approaches. They often start with a DCF to anchor their views of a company’s future, then use trading comps to supplement the DCF’s outcome.

Rounding It All Up!

Valuation isn’t about finding a single “correct” number. It’s about using the right tools (absolute or relative) to make informed investment decisions. Absolute valuation models focus on a company’s fundamentals, while relative models derive value through comparison. 

The best investors and analysts use both to cross-check and supplement their assumptions to build a fuller picture of a company’s value. Remember:

A valuation model should guide your thinking – not replace it.

Use them wisely, apply critical judgment and let them support your understanding – not define it.