What is an Absolute Valuation Formula?
The term “absolute valuation” refers to the method of business valuation that utilizes DCF analysis to determine the fair value of the firm. This method helps in the determination of a company’s financial worth on the basis of its projected cash flows. Basically, the formula for discounted cash flow is calculated by adding up the cash flow in each period that is divided by one plus the discount rate which is again raised to the power of the number of periods.
Absolute Valuation Formula
This equation and the stock is represented as follows –
#1 –Absolute Valuation Formula of Business
Mathematically, the Absolute Valuation Equation can be represented as,
- CFi = Cash flow in the ith year
- n = Last year of the projection
- r = Discount rate
#2 – Absolute Valuation Formula of Stock
Finally, the absolute value of a stock equation is calculated by dividing the absolute value of the business by the number of outstanding shares of the company in the market and the absolute value of a stock is represented as,
Absolute value Stock = Absolute value Business / Number of outstanding shares
Explanation of the Absolute Valuation Formula
The formula for absolute valuation can be calculated by using the following steps:
Step 1: Firstly, the projected cash flow during a year is noted from the company’s financial projections. The cash flow can be in the form of dividend income, earnings, free cash flow, operating cash flow, etc. The cash flow for the ith year is denoted by CFi.
Step 2: Next, the weighted average cost of capital (WACC) of a company is usually taken as the discount rate because it denotes an investor’s expected required rate of return from investment in that company and it is denoted by r.
Step 3: Next, determine the terminal value by multiplying the cash flow of the last projected year by a factor which is usually the reciprocal of the required rate of return. The terminal value denotes the value of the assumption that the business will continue after the projected periods.
Terminal value = CFn * Factor
Step 4: Next, calculate the present values of all the cash flows by discounting them using the discount rate.
Step 5: Next, the equation of absolute valuation calculation for the particular company is done by adding up all the present values of the cash flows and the terminal value calculated in step 4.
Step 6: Finally, the absolute valuation of a stock can be calculated by dividing the value in step 5 by the number of shares outstanding of the company.
Absolute valuation Stock = Absolute valuation Business / Number of outstanding shares
Example of Absolute Valuation Formula (with Excel Template)
Let us take an example of a company ABC Ltd and a particular analyst is interested in predicting the fair value of the company based on the available financial information. The investor’s expected required rate of return in the market is 6%. On the other hand, the company has projected that the free cash flow of the company will grow at 7%. Determine the absolute value of the stock on the basis of the following financial estimates for CY19:
So, from the above-given data, we will first calculate the CF for CY19.
CF CY19 = NOPAT + Depreciation & Amortisation expense – Increase in Working Capital – Capital Expenditure during the year – Debt Repayment + Fresh Debt raised during the year
- $150.00 Mn + $18.00 Mn – $17.00 Mn – $200.00 Mn – $35.00 Mn + $150.00 Mn
- $66.00 Mn
Now, using this CF of CY19 and CF growth rate we will calculate the Projected CF for CY20 TO CY23.
Projected CF of CY20
- Projected CF CY20 = $66.00 Mn * (1 + 7%) = $70.62 Mn
Projected CF of CY21
- Projected CF CY21 = $66.00 Mn * (1 + 7%)2 = $75.56 Mn
Projected CF of CY22
Projected CF CY22 = $66.00 Mn * (1 + 7%)3 = $80.85 Mn
Projected CF of CY23
- Projected CF CY23 = $66.00 Mn * (1 + 7%)4 = $86.51 Mn
Now we will calculate the Terminal Value.
- Terminal value = CF CY23 * (1 / Required rate of return)
- $86.51 Mn * (1 / 6%)
- $1,441.88 Mn
Therefore, the calculation of absolute valuation will be as follows –
Calculation of Absolute valuation of Company
- Absolute Value = $1,394.70 Mn
Now, we will calculate the fair value of the stock which is as follows –
- The absolute valuation of the stock = Absolute valuation of company / Number of outstanding shares
- $1,394.70 Mn / 60,000,000
Calculation of Absolute valuation of Stock
Relevance and Use
From the perspective of a value investor, it is very important to understand the concept of an absolute valuation equation because it is used to check whether a stock is over or undervalued. However, it is very challenging to forecast the cash flows with certainty, the growth rate, and to assess how long the cash flows will continue to grow in the future. Therefore, this method should be used but with a pinch of salt.
This has been a guide to Absolute Valuation Formula. Here we discuss how to calculate Absolute valuation and Stock using practical examples along with downloadable excel template. You may learn more about Valuations from the following articles –