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Valuation Models

Difficulty intermediate

Overview

Valuation determines the intrinsic value of an asset. The core principle: buy when price < value, sell when price > value.

Discounted Cash Flow (DCF)

Concept

The value of an asset equals the present value of all future cash flows:

Value = Σ CF_t / (1 + r)^t

where: CF_t free cash flow in period t · r discount rate (typically WACC) · t time index does: the present-value sum of all forecast cash flows — the foundation of intrinsic valuation, best suited to mature businesses with predictable cash flows (industrials, consumer staples, established tech); avoid for early-stage or cyclical firms whose cash flows are too noisy to forecast.

Steps

  1. Forecast Free Cash Flows — Typically 5-10 years
  2. Calculate Terminal Value — Value beyond forecast period
  3. Discount to Present — Using Weighted Average Cost of Capital (WACC)
  4. Subtract Net Debt — Arrive at equity value
  5. Divide by Shares — Get per-share value

WACC Calculation

WACC = (E/V × Re) + (D/V × Rd × (1-T))

E = Market value of equity
D = Market value of debt
V = E + D
Re = Cost of equity (CAPM: Rf + β × ERP)
Rd = Cost of debt
T = Tax rate

where: E market value of equity · D market value of debt · Re cost of equity from CAPM · Rd pre-tax cost of debt · T marginal tax rate · Rf risk-free rate · β equity beta · ERP equity risk premium does: the blended after-tax cost of all capital sources — used as the discount rate inside DCF; the after-tax debt term reflects the tax shield on interest. Suited to mature firms with stable capital structure; replace with adjusted present value for highly leveraged or rapidly delevering firms.

Comparable Company Analysis

Method

  1. Select peer group
  2. Calculate valuation multiples
  3. Apply median/average to target

Key Multiples

Multiple Formula Best For
P/E Price / EPS Profitable companies
EV/EBITDA Enterprise Value / EBITDA Cross-border, different capital structures
P/S Price / Revenue Unprofitable, high-growth
P/B Price / Book Value Financials, asset-heavy
EV/Sales Enterprise Value / Sales Startups, SaaS
PEG P/E / Growth Rate Growth companies

Dividend Discount Model (DDM)

Gordon Growth Model

Value = D₁ / (r - g)

D₁ = Next year's dividend
r = Required return
g = Dividend growth rate

where: D₁ expected dividend one year out · r required equity return · g long-run dividend growth rate (must be less than r) does: the closed-form present value of a perpetually growing dividend stream — suited to mature dividend-payers with stable payout policies (utilities, consumer staples, large banks); useless for non-payers, hyper-growth firms, or any company whose dividend isn't reliably set by board policy.

Residual Income Model

Value = Book Value + Σ (RI_t / (1+r)^t)

RI_t = Net Income_t - (r × Book Value_{t-1})

where: Book Value opening shareholders' equity · RI_t residual income in period t · Net Income_t GAAP earnings in period t · r cost of equity does: prices equity as book value plus the present value of returns earned above the cost of capital — suited to financials (banks, insurers) and other firms where book value is meaningful and free cash flow is messy; the natural alternative to DCF for balance-sheet-driven businesses.

Asset-Based Valuation

Value = Fair Value of Assets - Liabilities

Best for: Real estate, holding companies, distressed firms

where: Fair Value of Assets mark-to-market value of all firm assets · Liabilities total interest-bearing and operating liabilities does: the net-asset-value floor — suited to real-estate vehicles, holding companies, closed-end funds, and distressed/liquidation cases where the going-concern assumption breaks down; not appropriate for asset-light businesses whose value sits in brand, IP, or recurring revenue.

Margin of Safety

Buy Price = Intrinsic Value × (1 - Margin of Safety)

Typical MoS: 20-50%

Benjamin Graham: "The margin of safety is always dependent on the price paid."

where: Intrinsic Value model output (DCF, DDM, or comps-based) · Margin of Safety discount to intrinsic value the buyer demands does: the discipline of buying below model value to absorb forecast error — used to set entry triggers and to scale required margin by forecast confidence (narrow moats and cyclicals need 30–50%; stable compounders can tolerate 15–20%).

Practical Guidelines

  1. Multiple Methods — Cross-validate with 2-3 approaches
  2. Sensitivity Analysis — Test different assumptions
  3. Garbage In, Garbage Out — Forecasts are only as good as assumptions
  4. Market Price ≠ Value — Price is what you pay, value is what you get
  5. Update Regularly — Revalue when new information emerges
  6. Be Conservative — Use conservative growth rates and discount rates
  7. Know the Limitations — No model is perfect

Next Steps