From PE Ratios to Discounted Cash Flows – Which Valuation Method is Best?

Are your holding onto employer stock that’s over- or under-valued?

Well, you’ve likely tried to read reports, blog posts, or talked to colleagues about the value of your company’s stock.

And so, when you’re faced with evaluating whether to hold your company stock for the long run or cut your holdings, the road ahead can seem fraught with a number of complex choices.

But you know, getting the answer to your question about the value of your company stock is actually simpler than you think.

That’s because when it comes down to it, there are two methods that professionals use to determine whether the price of a company’s stock is fairly valued or not.

And that’s the absolute valuation and relative valuation methods.

How do these approaches differ?

So, how do these approaches differ?

Well, an absolute valuation model like the Discounted Cash Flow (DCF) method looks at what’s called a stock’s intrinsic value.

This method forecasts expected future cash flows and adjusts for risk and time value of money—much like estimating all future earnings of a company and converting them into today’s dollar value.

On the other hand, relative valuation methods involve comparing a company to its industry peers.

Here, what we’re doing is using ratios such as Price-to-Earnings (P/E) so you can get a market-based perspective on whether what you’re holding is cheap or expensive.

The Strategic Advantage of a Dual Valuation Approach

So, which one should you use when it comes to valuing your equity compensation?

Well, consider both.

Because here’s the thing: if you’re a tech professional receiving equity as part of your compensation, then understanding both absolute and relative valuation methods will empower you to make informed, nuanced investment choices.

For example, when looking at absolute valuations, what you’re doing is isolating a stock’s value based on its internal potential and risks. In other words, does the price of the stock reflect the company’s future earnings potential?

In contrast, relative valuation situates a stock within the landscape of its peers, offering you a market-relative perspective on whether it’s time to hold or sell. In other words, is the dollar of earnings you’re paying for higher or lower compared to industry peers?

Why not just use one versus another?

And so, each method gives you a different lens to look through.

So then, why not use one versus another?

Well, by applying solely an absolute valuation approach, you’re potentially at risk of evaluating your company’s stock in a vacuum based on expected profits and risks.

However, by adding in relative valuation into the mix, what you’re doing is measuring how your company’s stock stacks up against similar companies. This approach ensures that you’re not just holding onto a high-flyer but also getting a good deal compared to its peers.

In fact, a study by the CFA Institute reveals that over 80% of successful equity fund managers use both techniques to build their portfolios.

They seek out stocks that are not only fundamentally solid but also attractive within their sector, striking a balance between intrinsic worth and extrinsic factors.

The Big Takeaway

Either way, when it comes down to it, this approach can help you assess your company’s stock’s true value and strategically decide when to hold or sell your equity stakes, which is crucial in a sector where innovations and market shifts often happen at a moment’s notice.

With that said, however, it’s worth noting that each method comes with its own challenges.

That’s because absolute valuations hinge heavily on the accuracy of your future earnings projections and discount rates, which can be highly subjective and vary with market conditions.

At the same time, relative valuations, while useful for contextual analysis, might lead you astray if the broader market is distorted by speculative bubbles or volatile investor sentiments.

That’s why merging these valuation strategies offers you a holistic view that reduces the risks associated with relying on a single method.

Nevertheless, staying informed and flexible in your approach can allow you to make smarter, more stable investment choices and position you for a more disciplined approach to managing a key component of your wealth.