Discounted cash flow and similar valuation methods are often cited as the only way to derive an intrinsic value of an equity investment that does not depend on how other assets are priced by the market. In contrast, valuation multiples, such as a price earnings ratio or EV/EBITDA, merely identify value relative to other assets.
However, this view is not only simplistic – both DCF and valuation multiples can be used in a so-called absolute and relative sense – but it can also be incorrect. We argue that everything is relative in valuation. All equity values, including those presented in financial statements, are measured relative to either current or historical market prices
We recently came across this comment on an investment forum regarding equity valuation:
“Most investors are focused on relative valuation metrics instead of calculating intrinsic value. Value is intrinsic, it does not depend on the value of others. So why do so many value a company based on metrics like the price earnings ratio?”
The comment refers to the benefits of discounted cash flow valuation (and DCF equivalents such as residual income) where the output is often referred to as an absolute or intrinsic value that reflects the fundamental drivers of company value, such as cash flows, returns and growth. The argument is that, in an investment approach based on finding undervalued stocks, market prices should be compared with estimates of intrinsic value, for which DCF is the best candidate. In contrast, valuation multiples, such as a price earnings ratio, always include market prices as an input and therefore can only tell investors how a company is valued relative to the price of others.
Although the term intrinsic value can be used in different ways, the comment above that an intrinsic value “does not depend on the value of other [stock]s” is a common interpretation. However, we question whether any value, including those derived using a DCF approach, can be measured without any reference to observed prices and, therefore, whether it is possible for any value to be truly ‘intrinsic’ – more on this later.
Absolute versus relative value
The meaning of the terms absolute value and relative value are reasonably clear. An absolute value is where the model output is a target stock price, whereas relative valuation techniques provide some measure of how an observed market price compares with those of other companies. However, equity valuation is more nuanced than simply characterising valuation techniques as deriving either absolute or relative values. Both DCF and multiple based valuation techniques can be applied in a so-called absolute way but are also capable of providing relative valuation comparisons.
Furthermore, while multiples such as the price earnings ratio may appear simplistic, we do not think they should be dismissed as readily as the comment above suggests. Multiples provide a framework for making judgements about value; judgements that may be more difficult in a DCF valuation given the many inputs and moving parts.
DCF can be used in a relative sense
Although we normally think of DCF valuation as a way to derive absolute values, it can also be used to compare companies in a relative sense. Simply construct a DCF model based on your best estimate of all input assumptions and then flex one of these assumptions so that the DCF value equals the current stock price – this process is often called ‘reverse DCF’. Do the same thing for other companies and then compare the outcome for the flexed input.
Reverse DCF is a technique to make relative value comparisons that focus on specific value drivers
For example, you could flex the DCF model input for the long-term sustainable operating margin and compare the resulting ‘market implied’ margins for different companies in a sector. If one company has much lower market implied margins, and there is no clear economic reason for this, then the stock may be identified as cheap relative to the others.
A variation of this exercise fixes margins and ‘solves’ for the ‘market implied cost of equity’, which is the implied return or internal rate of return implied by the market price. This return is then compared with the implied return computed for other companies deemed to be close peers and traded as such by investors.
These approaches are a more sophisticated version of simple valuation multiple comparisons. Comparing say EV/EBIT is challenging, considering that there could be many reasons why the multiples of different companies should differ. Only after considering all these factors can a difference in multiple be explained by mispricing. Arguably, isolating these value drivers in a reverse DCF approach facilitates more informative relative value comparisons.
Multiples can be used in an absolute sense
Absolute value can be obtained by multiplying a relevant metric by a target multiple derived from comparable companies. For example, a company’s EPS multiplied by the average PE ratio of the relevant peer group gives an estimated equity value. Of course, the resulting value is arguably not truly absolute, nor would most investors likely characterise it as ‘intrinsic’, because it merely reflects how the market currently prices the peer group.
An alternative is to derive a target multiple from underlying fundamental value drivers and apply this to the relevant results metric. This is an approach we have demonstrated in other articles and associated interactive models, such as our two-stage target enterprise value multiple model.
Interactive model: Target enterprise value multiples
Click here for more about this model and to access a downloadable version.
However, these target multiples are, in reality, a simplified form of discounted cash flow. The target multiples in the above model are based on the same value drivers used in DCF, except without the detailed explicit forecast used in a typical DCF model.
The meaning of intrinsic value
A simple google search for intrinsic value will reveal how this term means different things to different investors. Some regard intrinsic value very widely as any valuation that is not the current stock price, including those derived from valuation multiples. For example …
However, others refer specifically to the application of a discounted cash flow approach where the focus is on business fundamentals …
A common theme in many of the explanations is that intrinsic value is independent of how other assets are priced by the market. It is an inherent value that is only based on business fundamentals, that does not incorporate market sentiment and the other factors that influence market prices …
And …
The comment on the investment forum that we initially highlighted is clearly a reference to intrinsic value being determined without reference to other market prices; we think this use of the term intrinsic value is the most common.
The investment approach of many long-term investors is to buy good quality companies at a price that is below their estimate of intrinsic value, with the belief that this value will eventually be recognised by the market and that this will drive superior investment returns. There is nothing wrong with this approach. However, we question whether the intrinsic value that these investors seek is actually possible.
In our view, no values can be truly independent of how the market prices other assets. A DCF approach may appear to provide an intrinsic value that is independent of market prices, given the focus on fundamental value drivers and the output of a deserved value. However, we do not think this is strictly true – the problem is the discount rate.
Intrinsic value may just be an illusion
All so-called intrinsic values are based on profit and cash flow forecasts, and are therefore estimated. Values inevitably differ depending on the valuer’s perspective and how model inputs are themselves determined. Nevertheless, value can still be regarded as intrinsic or absolute even with estimated cash flows.
Discount rates can only be determined relative to returns from other assets
However, we think estimates of the discount rate are different from estimates of future cash flows. Cash flows can be forecast without direct reference to other investment opportunities (even though data for other companies may help). However, a discount rate can only ever be estimated relative to the returns from other assets.
Estimating the discount rate
We know that the discount rate (or required rate of return) for equity investments must be more than the risk-free rate, given the higher risk. We also know that this risk factor differs depending on whether the DCF approach is based on equity or enterprise flows. In the case of an equity free cash flow valuation, the discount rate must reflect the risk to equity investors. For an enterprise DCF the discount rate must be deleveraged (delevered) and only reflect asset risk.5Although asset risk is the primary driver of WACC, financing side effects, notably the debt interest tax shield, are also relevant. If an asset beta is applied in CAPM the resulting required return is equal to the unlevered WACC. This produces a business value that excludes the value of the debt interest tax shield.
The problem is how high the discount rate needs to be to compensate investors for this risk. While it has significant limitations, the most common approach applied in practice is the Capital Asset Pricing Model (CAPM)6Although widely used in practice CAPM has many critics. The assumptions on which it is based and the limited evidence for its relevance in explaining stock returns mean it should be used with caution. However, there is no accepted better alternative. For a good explanation about the limitations of CAPM see ‘CAPM: An absurd model’ by Pablo Fernandez., where the risk adjusted rate is a function of a market equity risk premium and a beta factor.
Discount rate = Risk free rate + Equity risk premium x Beta factor
Beta factors simply scale the equity risk premium to derive a stock specific risk premium
Beta, as a measure of systematic (systemic) risk, is difficult to pin down. Historical calculations based on samples of price movements often suffer from a high margin of error and, of course, being backward looking, they measure past risk which may no longer be relevant if there have been subsequent changes in the business or leverage. Historical measures can only help in estimating a forward-looking measure of risk and are not the answer in their own right.
When calculating a CAPM discount rate, the beta factor, in effect, scales the equity risk premium by the ratio of the non-diversifiable risk of the asset relative to the risk of the market. While the risk of the asset is an absolute measure, the overall beta factor is measured relative to market risk. Whether this results in an absolute value depends on whether the equity risk premium is itself an absolute measure.
The equity risk premium
The equity risk premium is based on other assets and can only ever result in relative values
The equity risk premium (ERP) represents the additional return in excess of a risk-free rate that is required by investors to take on market risk – the risk of a diversified equity market portfolio or the average systematic risk of individual equity assets. Over the years we have observed many different figures used for the ERP. At the time of the tech bubble in the 1990s we saw some investors and analysts using rates below 3%. But we have also seen ERPs for developed markets well above 7%.
The problem is that the ERP is not observable and there is no universal truth as to what it should be. However, an ERP can be implied and estimated. There are several ways of doing this.
- Current implied ERP: The implied discount rate obtained from a reverse DCF – the ERP which when included in a DCF for a market index, based on current consensus forecast cashflows, produces the current index value. The answer clearly depends on the assumptions made about future cash flows included in the DCF model.
- Historical realised ERP: The average historical difference between the realised return on equities and risk-free bonds. Different calculation methods and different time periods selected can produce very different results.
- Historical implied ERP: The average of the implied ERP calculated as above but taken over a certain historical period. This depends not only on how the DCF model is structured but also the period selected.
- Volatility adjusted historical ERP: It is well known that market prices react inversely with changes in market volatility. One approach to make historical ERP estimates more current is to adjust to reflect how current market volatility (either observed or implied from derivative prices) compares with average historical market volatility.
- Investor judgement ERP: The ERP is the return that an investor thinks that the market requires (or will in the future require) to purchase equity assets. In other words, it is the average ‘price setting’ view of other investors. This may be deduced simply based on experience or a survey of other investors, perhaps additionally informed by the results of the other approaches above.
But each of these methods will result in a DCF valuation being relative to whatever values the ERP was derived from.
A relative ERP produces a relative value
Considering there is no absolute equity risk premium then, in our view, it is not possible to use DCF value to obtain an intrinsic value that is independent of other market prices. Even though some components of DCF are absolute and do not depend on other investments, such as estimates of profit and cash flows, the overall outcome is still relative. DCF values, and the equity risk premium on which they depend, can only ever be based on past prices, past prices adjusted to allow for current conditions (such as volatility adjustments), or current prices.
Ultimately, investing based on estimates of so-called intrinsic value all comes down to relative comparisons combined with investor judgement. How does your judgement, including that of the appropriate risk-adjusted required return, differ from that of other investors and how you believe the judgements of those other investors will change?
If asked, we will tell you that we think the equity risk premium for developed markets is 5%. However, we have no special insight and would defer to others who think a lot more about this issue and are closer to the market than we are. For example, Dave Bianco, our friend and former colleague at UBS, one time chief US Strategist at Bank of America Merrill Lynch and now Americas CIO at DWS, used 4.75% in his ‘intrinsic’ valuation framework for the US market earlier last year, as he explained in his June 2022 ‘CIO view’ publication.
Extract from the DWS ‘Americas CIO View’ publication
DWS Americas CIO View June 13, 2022
Dave’s estimate of 4.75% is an example of the ‘Investor Judgement’ based ERP that we describe above. How this differs from the market implied ERP, combined with differences in the estimate of other components of value, determines how his valuation of US equities differs from current market prices.
Dave subsequently raised his ERP estimate to 5.0% later in 2022 citing, in part, equity volatility and specifically the rise in the VIX7The VIX index is the 1-month forward implied volatility of the S&P 500 index derived from index option prices. Over the last 10 years the average VIX value has been about 18%. In October 2022 the index reached over 33% before falling to its current level of about 21%. This is a good example of a volatility adjusted ERP that we describe above. Most recently, in his ‘Investment themes and views for 2023’, he uses an ERP of 4% in the context of his comments on the US market forward price earnings ratio. He does not go into any detail about the rationale for the 4%, but we note that the VIX index he cites in 2022 has now declined significantly.
The equity risk premium in financial reporting
Current asset values are used in many aspects of financial reporting, such as purchase price allocations, the measurement of financial instruments and in asset impairments. Most of these values are ‘fair value’ which is defined as a market price – the price that an asset can currently be sold for in an active market or, if no such market is available, an estimate of what the price would be if there were an active market.
For impairments of non-financial assets, value-in-use may also be used in IFRS accounting (but not US GAAP). Value-in-use differs from fair value in terms of the valuation perspective and basis for estimating cash flows; however, the discount rate applied when DCF is used to estimate value-in-use is the same as for fair value.
For more about asset impairments, and the use of fair value and value-in-use, see our article ‘Associate impairments may not reflect the underlying economics’.
Unless a quoted price or other market-based price data is available for an asset (and always for value-in-use), fair value requires a DCF calculation for which a discount rate must be estimated. These model-based fair value measures are described as ‘level 3’ values. The market price objective of fair value means that the current market implied equity risk premium must be used as an input for the discount rate calculation, although clearly the ERP and related risk adjustments have to be estimated, and different valuers will likely come to different conclusions.
IFRS uses both value-in-use and fair value for impairment testing
One of the challenges for investors when assessing fair value and value-in-use measures in financial reporting is in identifying whether the key assumptions used are realistic. While the discount rate applied is almost always disclosed, we rarely see how this was derived. In particular, companies tend not to specify what equity risk premium they used.
In the extract below, Mining company BHP reported over $3bn of impairments in 2021, The real post-tax discount rate applied in calculating recoverable amount for the assets that resulted in most of this impairment was 6.5%.
BHP financial statements 2021
While BHP complies with the IFRS disclosure requirements, we do not think that merely disclosing the overall discount rate gives investors sufficient information to assess the impairments. Because the recoverable amount cannot be measured independent of other market prices due to the use of a market-based discount rate, we think that it is particularly important to understand what equity risk premium was used in calculating that discount rate.
Equity risk premium used for impairment testing discount rates should be disclosed
The IASB are currently considering how impairment testing can be simplified and made more effective. We think that the relevance of impairment information for investors would be improved if the equity risk premium that is incorporated into the discount rate were separately disclosed.
Insights for investors
- DCF analysis can be used for relative valuation comparisons that are more sophisticated than those based on valuation multiples.
- The equity risk premium is an elusive concept. The same term can be applied to historical realised excess equity returns as well as an estimated implied excess return implicit in current market prices.
- Because there is no absolute equity risk premium, all so-called intrinsic value estimates must be relative to something, whether past prices, current prices or an individual investor’s perception of what current prices should be.
- In financial reporting an equity risk premium is implicit in both fair value and value-in-use estimates. Consequently, we consider these are also relative and not absolute measures of value. Disclosure of the equity risk premium on which these values are based would help investors.
In developing this article we benefited from several discussions with reviewers. Thanks in particular to Dan Stillit of Adjunct Value Partners and Imperial College Business School, and Patrick O’Bryan our (now retired) former colleague at UBS.