Rather than producing your own valuation and comparing it with the price, take the price as given and solve for the growth or margins it assumes. Then judge whether those assumptions are plausible.
11 min read · Level 3
Reverse valuation is the most honest use of a model I know, because it stops you from choosing the inputs that produce the answer you wanted. Once the price is fixed and the assumption falls out of the arithmetic, you either believe the assumption or you do not, and that is a much harder position to fudge.
A forward valuation asks what a company is worth. A reverse valuation asks what the market's price assumes, which is often more useful because it produces a testable claim.
Using a simple growth model, value equals next year's cash flow divided by the discount rate minus the growth rate:
Value = Cash flow / (r - g)
A share trades at 50 with earnings of 2 per share, and you require an 8% return:
50 = 2 / (0.08 - g) 0.08 - g = 2 / 50 = 0.04 g = 4%
The price implies earnings growing about 4% a year forever. Now the question is answerable: has this company grown faster or slower than that, and is 4% perpetual growth plausible for its industry?
Compare with a company trading at 20 with the same earnings:
20 = 2 / (0.08 - g) 0.08 - g = 0.10 so g = -2%
That price implies earnings shrinking 2% a year forever. If the business is merely mature rather than declining, the price may be low relative to a reasonable view.
The same approach works with more detailed models: hold the price fixed and solve for the growth rate, margin or duration of growth that justifies it.
Because your own forecast is easy to bend toward the answer you want. Solving for the implied assumption produces a number you can check against history and industry evidence.
It also makes disagreement precise. Instead of arguing that a share is expensive, you can say the price assumes 12% growth for a decade while the company has grown 5%.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Three prices for the same company, earnings of 2 per share, required return 8%.
Price Implied perpetual growth 20 -2% 33 about 2% 50 4% 80 about 5.5%
At 80: 2 / 80 = 0.025, so g = 8% - 2.5% = 5.5%. The investor checked the company's revenue and earnings growth over ten years, which averaged about 3%, and its industry's long-run growth, which was similar. At 80 the price required the company to grow faster forever than it ever had; at 33 it required roughly its historical rate.
Producing a valuation, finding it close to the market price, and treating that as confirmation. Many models can be tuned to justify almost any price.
Start from the market price rather than your own estimate of value.
Rearrange the model to find the implied growth rate, margin or growth duration.
Compare the implied figure with the company's own history and industry growth.
Express your view as a difference in assumptions rather than as expensive or cheap.
When a company's price seems high or low, or when comparing your view with the market's.
Do not use a simple perpetual growth model for companies with volatile or negative cash flows, where it produces meaningless results.
Analysts using reverse discounted cash flow techniques during periods of high valuations have frequently pointed out that prices implied growth rates sustained for a decade or more that few companies in history have achieved, a critique applied to various high-growth sectors in different market cycles.
Compare implied growth not only with the company's history but with the best comparable companies ever achieved.
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