Valuing a company is one of the most important skills in investing. It tells you whether a stock is cheap, fairly priced, or too expensive. While the full valuation process can be extensive and detailed, the core logic behind it can be understood through three major approaches.
This article walks you through the three widely used valuation methods:
Intrinsic Valuation, Relative Valuation, and Option-Based Valuation.
1. Intrinsic Valuation (DCF Method)
Intrinsic valuation estimates the true, inherent worth of a company based purely on its financial strength and ability to generate future cash flows.
The DCF (Discounted Cash Flow) Approach
The most popular tool in intrinsic valuation is the DCF model. It answers one question:
What is the present value of all the future free cash flows the company is expected to generate?
A DCF model factors in:
- Free Cash Flow (FCF)
- Growth rate of future cash flows
- Risk associated with the business (discount rate)
- Terminal value of the company
When everything is fed into the model, the output is the intrinsic value of the stock.
If Intrinsic Value > Market Price → Stock is undervalued (Buy)
If Intrinsic Value < Market Price → Stock is overvalued (Avoid/Sell)
When DCF Cannot Be Used
DCF fails when:
- The company has negative or inconsistent free cash flows
- The business is too early-stage to project growth reliably
In such cases, analysts shift to the next method.
2. Relative Valuation (Comparative Approach)
Relative valuation assesses a company by comparing it to others in the same industry or sector.
This method works like comparing house prices in the same locality.
Instead of trying to find the exact worth, you compare valuation multiples such as:
- Price-to-Sales (P/S)
- Price-to-Book (P/B)
- Debt-to-Equity (D/E)
- Price-to-Earnings (P/E)
- Cash flow metrics
How Relative Valuation Works
You take a company and compare these ratios against:
- Direct competitors
- Industry averages
- Sector leaders
This shows whether the company is:
✔ Cheaper than peers
✔ More expensive
✔ Fairly valued
Relative valuation is especially helpful when:
- Cash flows are negative
- The company is growing fast but hasn’t stabilized
- Forecasting future cash flows is difficult
It is quick, practical, and commonly used in daily equity research.
3. Option-Based Valuation (Event-Driven Valuation)
Option-based valuation is a modern, advanced approach.
It applies option pricing logic to businesses where value depends on a future event.
Example
A pharmaceutical company applies for a patent.
- If the patent is approved → The company’s value increases dramatically
- If rejected → The value collapses
This creates an “option-like” structure because the company’s worth depends on a binary outcome.
Option-based valuation uses formulas like:
- Black-Scholes model
- Binomial option pricing
This method is used when:
- A company has exploratory assets (mining/oil)
- Patent approval is pending
- Regulatory clearances drive future value
- New product launches can drastically change valuation
It is complex and usually handled by professional analysts.
Which Method Should Investors Learn First?
For most retail investors, the practical approach is:
✅ Start with Intrinsic Valuation (DCF)
It helps you understand long-term value and cash-flow fundamentals.
✅ Master Relative Valuation
It helps you compare companies quickly and efficiently.
❌ Option-Based Valuation is advanced
Learn it later once you’re comfortable with the first two techniques.
Final Thoughts
Valuation is not about predicting the future perfectly—it’s about building a logical, disciplined framework to judge a company’s worth. By understanding intrinsic, relative, and option-based valuation techniques, you gain a complete toolbox to analyze businesses from multiple angles.
To go deeper, you can explore financial modeling tutorials where these valuations are built step-by-step in Excel.
%20(2).png)
0 Comments