Valuing a company is a detailed and multi-step process, usually done through structured financial models. While complete valuation requires extensive work, every investor should understand the three standard methods used across the finance world.
Below is a clear overview of these three techniques.
1. Intrinsic Valuation (DCF Approach)
Intrinsic valuation focuses on estimating a company’s true, internal worth based on its future ability to generate cash.
Key Tool: DCF – Discounted Cash Flow Model
The DCF model evaluates: in these cash flows
All these components are combined to produce the intrinsic value of the company.
If intrinsic value > market price → undervalued (potential buy)
If intrinsic value < market price → overvalued (avoid/sell)
When DCF Cannot Be Applied
You cannot use DCF when:
- The company has no positive free cash flow
- Cash flows are unpredictable or unstable
- The business is too early-stage to forecast
In such cases, investors shift to relative valuation.
2. Relative Valuation (Peer Comparison)
Relative valuation compares a company with its competitors in the same sector to judge whether it is cheap or overpriced.
Common Metrics Used
- Price-to-Sales (P/S)
- Price-to-Book (P/B)
- Price-to-Earnings (P/E)
- Cash flow multiples
- Debt-to-Equity (D/E)
The idea is simple:
If two companies operate in the same business, their valuations should be comparable.
By examining key ratios across companies, investors decide whether a stock is priced attractively relative to peers.
When Relative Valuation Is Useful
- When DCF is impossible due to lack of cash flow
- When the business is growing but not stable
- When a quick comparison is needed
This method is widely used by analysts for screening and benchmarking.
3. Option-Based Valuation (Event-Driven Valuation)
Option-based valuation deals with companies whose value depends on specific future events. This method borrows principles from option pricing models used in derivatives.
Example
Consider a pharmaceutical company waiting for a patent approval.
- If the patent is approved → company value jumps
- If rejected → value drops sharply
This is similar to an “option payoff,” where value is unlocked only if a certain event occurs.
When This Method Is Used
- Drug approvals
- Mining or oil exploration outcomes
- Regulatory permissions
- Technology breakthroughs
Why It’s Complex
Option-based valuation requires advanced tools such as:
- Black-Scholes model
- Binomial options model
It is more sophisticated than intrinsic or relative valuation and used mainly in specialized cases.
Which Approach Should Investors Learn First?
For most equity investors:
✔ Start with Intrinsic Valuation (DCF)
Build a foundation in cash flow-based valuation.
✔ Learn Relative Valuation
Essential for comparing companies within the same industry.
✔ Explore Option-Based Valuation only after the first two
It is advanced and needed only in specific situations.
