Investment Valuation Methods

Why This Matters

Investment valuation sits at the heart of Business Economics because every capital allocation decision—whether a firm should acquire another company, launch a new project, or an investor should buy a stock—depends on determining what something is actually worth. You're being tested on your ability to distinguish between intrinsic valuation (what an asset should be worth based on fundamentals) and relative valuation (what the market says similar assets are worth). Understanding these methods means understanding how businesses make decisions under uncertainty.

The key insight examiners want you to demonstrate is when to use which method. A DCF analysis tells you something completely different from a P/E ratio, and choosing the wrong tool leads to wrong conclusions. Don't just memorize formulas—know what assumptions each method makes, what type of company or project it works best for, and how the methods connect to broader concepts like time value of money, risk adjustment, and market efficiency.

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Intrinsic Valuation: Time Value of Money Methods

These methods calculate what an investment should be worth by discounting future cash flows to the present. The core principle: a dollar today is worth more than a dollar tomorrow because of opportunity cost and risk.

Discounted Cash Flow (DCF) Analysis

• Projects all future free cash flows—then discounts them to present value using the weighted average cost of capital (WACC) as the discount rate
• Intrinsic value focus means DCF reveals what a company is fundamentally worth, independent of current market sentiment
• Best for stable, predictable businesses where cash flows can be reasonably forecasted; highly sensitive to discount rate assumptions

Net Present Value (NPV)

• Subtracts initial investment from present value of future cash inflows—expressed as $NPV = \sum \frac{CF_t}{(1+r)^t} - C_0$
• Decision rule is binary: positive NPV means the project creates value; negative NPV means it destroys value
• Capital budgeting cornerstone used for go/no-go decisions on projects, expansions, and equipment purchases

Internal Rate of Return (IRR)

• The discount rate that makes NPV equal zero—essentially the project's breakeven cost of capital
• Compare IRR to hurdle rate: if IRR exceeds the required return, the investment is attractive
• Limitation with non-conventional cash flows—projects with alternating positive and negative cash flows can produce multiple IRRs

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Intrinsic Valuation: Dividend-Based Methods

These methods value stocks specifically by forecasting the dividends shareholders will receive. The underlying assumption: a stock's value equals the present value of all future dividends.

Dividend Discount Model (DDM)

• Values stock as present value of expected future dividends—requires estimating dividend payments and an appropriate discount rate
• Assumes dividends are the primary return—making it ideal for mature, dividend-paying companies like utilities
• Limited applicability for growth companies that reinvest earnings rather than paying dividends

Gordon Growth Model

• Simplifies DDM by assuming constant dividend growth—formula is $P_0 = \frac{D_1}{r - g}$ where $D_1$ is next year's dividend, $r$ is required return, and $g$ is growth rate
• Only works when $r > g$—if growth rate exceeds discount rate, the formula produces meaningless results
• Quick valuation tool for stable blue-chip stocks with predictable dividend policies

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Relative Valuation: Market Multiples

These methods determine value by comparing a company to similar firms trading in the market. The core principle: similar assets should trade at similar prices, so we can use market data to establish benchmarks.

Price-to-Earnings (P/E) Ratio

• Calculated as $P/E = \frac{Market\ Price\ per\ Share}{Earnings\ per\ Share}$—shows what investors pay for each dollar of earnings
• High P/E suggests growth expectations; low P/E may signal undervaluation or that the market sees problems ahead
• Industry-specific comparisons only—a tech company's P/E cannot meaningfully be compared to a utility's P/E

Price-to-Book (P/B) Ratio

• Compares market value to book value of equity—calculated as $P/B = \frac{Market\ Price\ per\ Share}{Book\ Value\ per\ Share}$
• P/B below 1.0 may indicate undervaluation—the market values the company at less than its accounting net worth
• Most useful for asset-heavy industries like banking, real estate, and manufacturing where book value is meaningful

Enterprise Value/EBITDA (EV/EBITDA)

• Uses enterprise value (market cap + debt - cash) divided by EBITDA to measure total firm value relative to operating earnings
• Capital structure neutral—unlike P/E, this ratio allows comparison of companies with different debt levels
• Preferred by M&A analysts because it reflects what an acquirer would actually pay for the entire business

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Relative Valuation: Comprehensive Approaches

Comparable Company Analysis

• Systematic comparison using multiple valuation ratios—typically includes P/E, EV/EBITDA, P/B, and revenue multiples
• Requires identifying truly comparable peers—same industry, similar size, comparable growth prospects, and risk profiles
• Reflects current market conditions—provides a reality check on intrinsic valuations but can be misleading if the entire sector is over- or undervalued

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Asset-Based Valuation

This approach values a company based on what its assets are worth, rather than its earning power. The principle: a company is worth at least the liquidation value of its assets minus liabilities.

Asset-Based Valuation

• Calculates net asset value (NAV)—total assets (tangible and intangible) minus total liabilities
• Floor value in distressed situations—establishes minimum worth if the company were liquidated and assets sold
• Best for holding companies and asset-rich firms—less relevant for service businesses where value lies in human capital and relationships

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Quick Reference Table

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Self-Check Questions

1. Which two valuation methods both rely on discounting future cash flows but answer fundamentally different questions—one giving a dollar amount and one giving a percentage?

2. A company pays no dividends and reinvests all earnings for growth. Which valuation methods would be inappropriate to use, and what would you use instead?

3. Compare and contrast P/E ratio and EV/EBITDA: when would each give you a more accurate picture of relative value, and why does capital structure matter?

4. If an FRQ presents two mutually exclusive projects with different initial investments and asks which creates more value, which method should you use and why might IRR mislead you?

5. A manufacturing company with significant real estate holdings is being valued. Which methods would provide a "floor" value versus a "going-concern" value, and how might you reconcile differences between them?