Intrinsic vs. Relative Valuation#

There are two primary ways to determine what a company is worth. One looks inward at the company's cash generation, while the other looks outward at the market.

1. Intrinsic Valuation#

The Philosophy: An asset is worth the present value of the expected future cash flows it will generate.

The Primary Tool: Discounted Cash Flow (DCF) analysis.

In this method, you don't care what the market thinks the stock is worth today. You build a model to forecast:

1. How much cash the company will generate.
2. How risky those cash flows are.
3. What that cash is worth in today's dollars (Time Value of Money).

Analogy: The Rental Property#

You want to buy an apartment building. You don't look at Zillow to see what other buildings cost. Instead, you calculate:

• Rent collected per month ($2,000)
• Minus maintenance/taxes ($500)
• = Net Cash ($1,500)
• Value = The sum of that $1,500/month for the next 20 years. This is Intrinsic Valuation. You are valuing the cash, not the building.

Pros:

• Forces you to understand the business drivers (margins, growth, risk).
• Less influenced by market moods/bubbles.
• Focuses on the long-term fundamentals.

Cons:

• Highly sensitive to assumptions ("Garbage in, Garbage out").
• Requires more time and effort.

2. Relative Valuation#

The Philosophy: An asset is worth what similar assets are trading for in the market.

The Primary Tool: Pricing Multiples (e.g., P/E Ratio, EV/EBITDA, P/Sales).

In this method, you look at "comparable" companies (peers). If Company A trades at 20x earnings and Company B is similar but trades at 10x earnings, Company B might be "relatively" undervalued.

Analogy: House Shopping with Comps#

You want to buy a house. You look at what the 3 neighbors sold their houses for last month.

• Neighbor A (3 bed/2 bath): Sold for $400k.
• Neighbor B (3 bed/2 bath): Sold for $410k.
• Your Conclusion: This house is worth about $405k. This is Relative Valuation. You value the market price, not the cash flow.

Pros:

• Quick and easy to calculate.
• Reflects current market sentiment (useful for short-term trading).
• Requires fewer assumptions.

Cons:

• The "Bubble" Trap: If the whole neighborhood is overpriced (a housing bubble), relative valuation will tell you a house is "cheap" at $1M just because the neighbor sold for $1.1M. It won't tell you the house is intrinsically worthless.
• Finding truly "comparable" companies is difficult.

Which is Better?#

Neither is perfect. They are complementary tools.

• Use Intrinsic Valuation (DCF) when you want to know if a stock is a good long-term investment based on its own merits, regardless of market noise.
• Use Relative Valuation as a "sanity check." If your DCF says a stock is worth $100, but it trades at $50 and all its peers trade at $50, you might be missing a risk factor that the market sees.