Intrinsic Valuation
Focus: Determines the inherent value of a company based on its fundamentals (e.g., discounted cash flows).
Assumption: Markets are inefficient in the short term, meaning they can make mistakes in pricing assets. However, they will eventually correct these mistakes over time.
Investors' Approach: If you believe that markets will eventually align with a company's true value, you'll focus on intrinsic valuation to guide long-term investments. It aligns with the philosophy that each asset has an intrinsic worth tied to its ability to generate future cash flows.
Relative Valuation
Focus: Evaluates a company based on how similar firms or assets are priced in the market (e.g., using valuation multiples like P/E ratios).
Assumption: Markets may incorrectly price individual stocks, but they are generally correct on average for a sector or asset class.
Traders' Approach: If you are skeptical of the concept of intrinsic value and believe prices reflect supply-demand dynamics without necessarily aligning with intrinsic worth, you would prefer relative valuation. Traders are more concerned with how assets are priced compared to their peers and how they can profit from market movements in the near term.
Contrasting Outcomes
Example: In early 2000, Amazon.com was overvalued when assessed through discounted cash flow (DCF) analysis, but relative valuation showed that it was undervalued compared to other internet companies. The market's bias towards internet stocks during the dot-com bubble inflated relative valuations.
This dichotomy can be explained by the different assumptions:
Intrinsic valuation: The market has temporarily mispriced the entire sector, which will correct itself.
Relative valuation: The market has correctly priced the sector on average, and any undervaluation or overvaluation is within this context.
Philosophy of Investment vs. Trading
Investors: If you see value as something intrinsic to an asset and believe that markets will eventually recognize this value, you are an investor. Investors look for assets where current market prices deviate from intrinsic value, betting on eventual convergence.
Traders: If you see market prices as driven by temporary factors like liquidity, sentiment, or momentum and are unconcerned with intrinsic value, you're a trader. Traders focus on price action and relative movements to exploit market inefficiencies.
In conclusion, the choice between intrinsic and relative valuation depends on whether you believe in market correction towards true value (investor) or prefer to capitalize on temporary pricing discrepancies (trader).
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