Company Valuation: A Simple Overview of the Three Main Techniques

 

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.