Valuation Methods

Why This Matters

Valuation sits at the heart of every major corporate decision—whether you're analyzing an acquisition target, evaluating a stock, or assessing strategic alternatives. You're being tested on your ability to select the right valuation method for a given situation and understand why different approaches yield different answers. The key isn't just knowing formulas; it's recognizing when each method applies and what assumptions drive the output.

These methods fall into distinct categories based on their underlying logic: intrinsic value approaches that build from fundamentals, relative value approaches that benchmark against peers, and specialized techniques for unique situations like buyouts or strategic flexibility. Don't just memorize the mechanics—know what each method assumes about value creation and when those assumptions break down.

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Intrinsic Value Methods

These approaches calculate what a company is fundamentally worth based on its own cash flows, earnings, or dividends—independent of what the market currently thinks. The core principle: a company's value equals the present value of the economic benefits it will generate.

Discounted Cash Flow (DCF) Analysis

• Projects future free cash flows—then discounts them to present value using the weighted average cost of capital (WACC) to determine intrinsic worth
• Terminal value typically represents 60-80% of total DCF value, making growth rate assumptions in perpetuity critically important
• Gold standard for intrinsic valuation because it forces explicit assumptions about growth, margins, and risk—but garbage in means garbage out

Dividend Discount Model (DDM)

• Values equity as the present value of expected dividends—calculated as $P_0 = \frac{D_1}{r - g}$ in the Gordon Growth Model
• Requires stable, predictable dividend policy to be meaningful; best suited for mature companies like utilities or REITs
• Assumes constant growth rate $g$ in perpetuity, which limits applicability for high-growth or non-dividend-paying firms

Economic Value Added (EVA)

• Measures true economic profit by subtracting capital charges from net operating profit: $EVA = NOPAT - (WACC \times Invested\ Capital)$
• Focuses on value creation above cost of capital—a positive EVA means the company is generating returns exceeding what investors require
• Aligns management incentives with shareholder value by making the cost of capital explicit in performance measurement

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Relative Valuation Methods

These approaches determine value by comparing a company to similar firms or transactions. The core principle: similar assets should trade at similar prices, so market multiples from comparable companies provide valuation benchmarks.

Comparable Company Analysis (Multiples)

• Derives valuation from peer trading multiples—common metrics include $EV/EBITDA$, $EV/Revenue$, and $P/E$ ratios applied to target financials
• Reflects current market sentiment and provides a reality check against intrinsic methods, but assumes comparables are fairly valued
• Selection of peer group is critical—companies must share similar growth profiles, margins, and risk characteristics to be truly comparable

Precedent Transactions Analysis

• Uses multiples paid in actual M&A deals involving similar companies to establish valuation ranges
• Captures control premiums typically 20-40% above trading prices, reflecting the value buyers pay for strategic control
• Reflects historical market conditions—a deal done in a frothy market may not be relevant in a downturn

Earnings-Based Methods (P/E Ratio)

• Compares stock price to earnings per share—calculated as $P/E = \frac{Price\ per\ Share}{Earnings\ per\ Share}$
• Simple and widely quoted but easily distorted by accounting choices, one-time items, and capital structure differences
• Forward P/E uses projected earnings and is generally more useful than trailing P/E for valuation purposes

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Asset-Based Methods

These approaches value a company based on what it owns rather than what it earns. The core principle: a company is worth at least the liquidation value of its assets minus liabilities.

Asset-Based Valuation

• Calculates net asset value (NAV) by summing fair market value of all assets and subtracting total liabilities
• Most relevant for asset-heavy businesses like real estate, natural resources, or financial holding companies
• Understates value for going concerns because it ignores intangible assets, synergies, and future earnings potential

Market Capitalization Method

• Equals share price times shares outstanding—the simplest measure of what the market believes a company is worth today
• Reflects real-time market perception but can be highly volatile based on sentiment, news flow, and broader market conditions
• Only captures equity value—must add debt and subtract cash to derive enterprise value for meaningful comparisons

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Specialized Valuation Techniques

These methods address specific situations where standard approaches fall short—strategic flexibility, leveraged transactions, or complex capital structures.

Real Options Valuation

• Captures the value of managerial flexibility—the option to expand, delay, or abandon projects as uncertainty resolves
• Applies option pricing theory (like Black-Scholes) to strategic decisions where traditional DCF undervalues flexibility
• Most useful for R&D, natural resources, and staged investments where management can adapt to changing conditions

Leveraged Buyout (LBO) Analysis

• Determines maximum acquisition price that allows financial sponsors to achieve target returns (typically 20%+ IRR) given debt capacity
• Focuses on cash flow for debt service—stable, predictable EBITDA and low capex requirements make ideal LBO candidates
• Works backward from exit assumptions—assumes a sale in 5-7 years and calculates what entry price supports required returns

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Quick Reference Table

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Self-Check Questions

1. A high-growth technology company that pays no dividends needs to be valued—which two methods would you eliminate immediately, and why?

2. Compare and contrast Comparable Company Analysis and Precedent Transactions Analysis: when would each produce a higher valuation, and what explains the difference?

3. If a DCF analysis produces a value of $800M$ but the company's market cap is $600M$, what are three possible explanations for the discrepancy?

4. A private equity firm is evaluating an acquisition—why might they use LBO analysis instead of DCF, and what key assumption drives the difference in approach?

5. For a natural resources company with significant oil reserves but uncertain commodity prices, which valuation method best captures the value of waiting to develop those reserves, and what makes it superior to standard DCF in this context?