Valuation methods typically fall into two main categories: absolute and relative.

Two Categories of Valuation Models

Absolute valuation models attempt to find the intrinsic or “true” value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividens, cash flow and growth rate for a single company, and you wouldn’t worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income models and asset-based models.

In contrast to absolute valuation models, relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods, which is why many investors and analysts start their analysis with this method.