Valuation of a Company – Key Techniques Explained

 

Understanding how to value a company is an essential skill for investors, but running a complete valuation model is a detailed exercise that normally requires spreadsheets and structured financial modeling.
This overview outlines the three primary approaches used across the investment world.

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1. Intrinsic Valuation (DCF Method)

Intrinsic valuation attempts to estimate what a company is truly worth based on its ability to generate future cash flows.

Core Tool: Discounted Cash Flow (DCF) Model

The DCF method takes into account:

• The free cash flows the business is expected to generate
• The growth rate of these cash flows
• The risk profile of the company (to determine the discount rate)

All these factors are combined to calculate the intrinsic value—a measure of whether the current market price is cheap or expensive.

When DCF Cannot Be Applied

DCF doesn't work if:

• The business has no positive free cash flow
• Cash flows are too volatile or unpredictable
• The company is too young to forecast

In such cases, analysts use relative valuation instead.

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2. Relative Valuation (Peer Comparison Method)

This approach values a company by comparing it with similar firms in the same industry.

How It Works

You examine widely used metrics such as:

• Price-to-Sales (P/S)
• Price-to-Book (P/B)
• Price-to-Earnings (P/E)
• Debt-to-Equity (D/E)
• Cash flow multiples

By comparing these variables across companies, you can determine whether a stock is overpriced or undervalued relative to its peers.

When This Method Is Useful

• When intrinsic valuation is not possible
• When you want quick screening
• When evaluating companies with limited historical data

Relative valuation is simple, practical, and highly popular among analysts.

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3. Option-Based Valuation (Event-Driven Valuation)

Some companies derive their value from uncertain future events.
In these cases, traditional valuation methods fall short.

Example

A pharmaceutical company awaiting a patent approval:

• If the patent is approved → company value jumps
• If not approved → value drops sharply

The payoff depends on the outcome, similar to a financial option.

How It Works

To value such companies, analysts use:

• Option pricing formulas (like Black–Scholes)
• Event-probability modelling

This method is advanced and used only when a company’s value hinges on a specific binary event.

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What Should an Investor Focus On?

A practical learning sequence is:

✔ Step 1 — Master Intrinsic Valuation (DCF)

Gives you a solid foundation in cash-flow-based valuation.

✔ Step 2 — Learn Relative Valuation

Crucial for comparing companies within an industry.

✔ Step 3 — Explore Option-Based Valuation (Advanced)

Useful only in special cases such as pharma, mining, or tech patents.