What is a stock really worth? This fundamental question drives all investment decisions. Professional investors use three main valuation methods to determine intrinsic value: Discounted Cash Flow, comparable companies analysis, and precedent transactions.
Why Valuation Matters
Price is what you pay. Value is what you get. Even the best company is a bad investment if you overpay.
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. But first, you must know what that fair price is.
— Warren Buffett
Company X fundamentals: Generates $100M in annual free cash flow, grows at 5%/year
10-year return: ~120% (8.2% annually)
10-year return: ~10% (1% annually)
Same company, same fundamentals—but Investor A's return is 12x better simply by paying the right price. Valuation determines your return.
Discounted Cash Flow (DCF) Valuation
The DCF model calculates a company's intrinsic value based on the present value of all future cash flows. It's the most theoretically sound valuation method—a company is worth the sum of all cash it will generate, discounted back to today.
The DCF Formula
Company Value = PV of Future Cash Flows + Terminal Value
Key Components:
- Free Cash Flow (FCF): Cash generated after capital expenditures
FCF = Operating Cash Flow - CapEx - Discount Rate (WACC): Weighted Average Cost of Capital—the return required by investors
Typically 8-12% for stable companies, 12-15%+ for growth companies - Terminal Value: Value of all cash flows beyond the projection period
Usually 70-80% of total company value - Projection Period: Typically 5-10 years of explicit forecasts
DCF Strengths and Weaknesses
Strengths
- ✓ Based on fundamental cash generation
- ✓ Independent of market sentiment
- ✓ Theoretically most accurate method
- ✓ Forces deep understanding of business
- ✓ Customizable to specific company dynamics
Weaknesses
- ✗ Highly sensitive to assumptions (GIGO)
- ✗ Difficult for unprofitable growth companies
- ✗ Terminal value dominates result (uncertain)
- ✗ Requires financial modeling skills
- ✗ Time-consuming to build properly
DCF Step-by-Step Example: Valuing a Coffee Chain
Let's value "JavaCo," a hypothetical coffee chain with stable cash flows.
- Revenue: $1,000M
- Operating Cash Flow: $150M
- Capital Expenditures: $30M
- Free Cash Flow: $120M
- Shares Outstanding: 100M
- Debt: $200M
- Cash: $50M
Step 1: Project Free Cash Flows (5 years)
Assumptions: Revenue grows 8% annually, FCF margin improves from 12% to 14%
| Year | Revenue | FCF Margin | Free Cash Flow |
|---|---|---|---|
| Year 1 | $1,080M | 12.5% | $135M |
| Year 2 | $1,166M | 13.0% | $152M |
| Year 3 | $1,259M | 13.5% | $170M |
| Year 4 | $1,360M | 13.8% | $188M |
| Year 5 | $1,469M | 14.0% | $206M |
Step 2: Calculate Terminal Value
Method: Perpetuity Growth Model
Terminal Value = Year 5 FCF × (1 + g) ÷ (WACC - g)
Perpetual growth rate (g): 3%
WACC (discount rate): 10%
Terminal Value = $206M × 1.03 ÷ (0.10 - 0.03) = $3,034M
Step 3: Discount All Cash Flows to Present Value
| Year | FCF | Discount Factor | Present Value |
|---|---|---|---|
| Year 1 | $135M | 0.909 | $123M |
| Year 2 | $152M | 0.826 | $126M |
| Year 3 | $170M | 0.751 | $128M |
| Year 4 | $188M | 0.683 | $128M |
| Year 5 | $206M | 0.621 | $128M |
| Terminal Value | $3,034M | 0.621 | $1,884M |
| Total Enterprise Value | $2,517M | ||
Step 4: Calculate Equity Value Per Share
Enterprise Value: $2,517M
Less: Net Debt ($200M debt - $50M cash): -$150M
Equity Value: $2,367M
Shares Outstanding: 100M
Fair Value Per Share: $23.67
Comparable Companies Analysis (Trading Comps)
Comparable companies analysis values a company based on how similar public companies are trading. If Company A trades at 15x earnings, and Company B is similar, it should also trade around 15x earnings.
How Comps Work
- 1. Identify Comparable Companies
Find 5-10 public companies in same industry, similar size, growth, and business model - 2. Calculate Valuation Multiples
Common multiples: P/E, EV/EBITDA, P/S, P/B, EV/FCF - 3. Take Median/Average
Find median multiple across comparable set (median is less affected by outliers) - 4. Apply to Target Company
Multiply target's metric by comparable multiple to get implied valuation
Common Valuation Multiples
| Multiple | Formula | Best For |
|---|---|---|
| P/E Ratio | Price ÷ Earnings Per Share | Profitable, mature companies |
| EV/EBITDA | Enterprise Value ÷ EBITDA | Capital-intensive businesses |
| P/S Ratio | Price ÷ Sales Per Share | Unprofitable growth companies |
| P/B Ratio | Price ÷ Book Value | Banks, asset-heavy firms |
| EV/FCF | Enterprise Value ÷ Free Cash Flow | Cash-generative businesses |
Target Company: "RetailCo" with $500M EBITDA
| Comparable | EV/EBITDA |
|---|---|
| Walmart | 10.2x |
| Target | 11.5x |
| Costco | 14.8x |
| Dollar General | 12.1x |
| Kroger | 9.8x |
| Median | 11.5x |
Calculation:
RetailCo EBITDA: $500M
Median EV/EBITDA: 11.5x
Implied Enterprise Value: $500M × 11.5 = $5,750M
If RetailCo has $200M net debt, equity value = $5,550M. Divide by shares outstanding to get price per share.
Comps Strengths and Weaknesses
Strengths
- ✓ Based on real market prices
- ✓ Quick and simple to calculate
- ✓ Reflects current market sentiment
- ✓ Easy to explain and understand
- ✓ Useful for relative value comparison
Weaknesses
- ✗ No two companies are perfectly comparable
- ✗ Market may misprice entire sector
- ✗ Doesn't capture unique competitive advantages
- ✗ Sensitive to market bubbles/crashes
- ✗ Hard to find good comps for unique businesses
Precedent Transactions (M&A Comps)
Precedent transactions analysis examines prices paid in past acquisitions of similar companies. This method answers: "What have acquirers historically paid for businesses like this?"
How It Works
- 1. Identify Relevant Transactions
Find M&A deals in same industry from last 2-5 years (recent transactions more relevant) - 2. Calculate Transaction Multiples
Same multiples as comps: EV/EBITDA, EV/Revenue, P/E at acquisition - 3. Apply Acquisition Premium
Acquirers typically pay 20-40% premium over trading price (control premium) - 4. Calculate Implied Value
Apply median transaction multiple to target company's metrics
Target: SaaS company with $200M revenue
| Transaction | Year | EV/Revenue | Premium |
|---|---|---|---|
| Salesforce acquires Slack | 2021 | 26.0x | 55% |
| Microsoft acquires Nuance | 2021 | 11.2x | 23% |
| Adobe acquires Figma | 2022 | 50.0x | N/A |
| Thoma Bravo buys Coupa | 2023 | 9.5x | 30% |
| Median (excl. outlier) | 11.2x | 30% | |
Implied Acquisition Value:
Target Revenue: $200M
Median EV/Revenue: 11.2x
Implied Value: $200M × 11.2 = $2,240M
This suggests an acquirer might pay ~$2.2 billion for the company. Current trading value might be 30% lower ($1,700M) before acquisition premium.
When to Use Precedent Transactions
- M&A situations: Valuing a company for sale or merger
- Strategic buyers: Understanding what acquirers might pay
- Fairness opinions: Determining if acquisition price is fair
- Active M&A sector: Industries with frequent consolidation
Real Example: Valuing Apple (AAPL)
Let's apply all three methods to value Apple as of January 2025.
Apple Financial Snapshot (FY2024)
- Market Cap: $3,500B
- Revenue: $385B
- Net Income: $97B
- Free Cash Flow: $108B
- Shares: 15.3B
- Current Price: ~$229
- Net Debt: $40B
- P/E Ratio: 36x
Method 1: DCF Valuation
Assumptions: 5% revenue growth, 28% FCF margin, 9% WACC, 3% terminal growth
5-year FCF projection: $108B → $113B → $119B → $125B → $131B
PV of 5-year FCF: $475B
Terminal Value: $131B × 1.03 ÷ (0.09 - 0.03) = $2,249B
PV of Terminal Value: $1,461B
Enterprise Value: $1,936B
Less Net Debt: -$40B
Equity Value: $1,896B ÷ 15.3B shares = $124/share
Method 2: Comparable Companies
| Company | P/E | EV/FCF |
|---|---|---|
| Microsoft | 38x | 32x |
| 28x | 24x | |
| Amazon | 42x | 35x |
| Meta | 32x | 28x |
| Median | 35x | 30x |
Apple Net Income × 35x P/E = $97B × 35 = $3,395B ($222/share)
Apple FCF × 30x = $108B × 30 = $3,240B ($212/share)
Comps Average: ~$217/share
Method 3: Valuation Summary
| Method | Value/Share | Interpretation |
|---|---|---|
| DCF | $124 | Conservative—implies undervalued |
| Comps | $217 | Market-based—suggests fair value |
| Current Price | $229 | Trading at premium to comps |
Conclusion: Apple trades at $229, between DCF ($124) and comps ($217). The premium reflects Apple's brand strength, ecosystem lock-in, and consistent execution. Investors are paying for quality and growth certainty.
Real Example: Valuing Tesla (TSLA)
Tesla is notoriously difficult to value due to its growth, volatility, and debates over whether it's a car company or tech company.
Tesla Financial Snapshot (2024)
- Market Cap: $800B
- Revenue: $97B
- Net Income: $15B
- Free Cash Flow: $6B
- P/E Ratio: 53x
- P/S Ratio: 8.2x
- EV/FCF: 133x
- Growth Rate: 20%+
Comparable Companies: The Challenge
| Comp Set | Median P/E | Implied TSLA Value |
|---|---|---|
| Auto (Ford, GM, Toyota) | 8x | $120B (85% undervalued) |
| Tech (Google, Meta, NVDA) | 35x | $525B (35% undervalued) |
| Current Trading | 53x | $800B (market price) |
The problem: Traditional auto comps suggest massive overvaluation. Tech comps suggest moderate overvaluation. Which is right?
Growth-Adjusted Valuation (PEG Ratio)
PEG Ratio = P/E ÷ Growth Rate (lower is better, <1.0 = potentially undervalued)
Tesla: 53 P/E ÷ 25% growth = PEG of 2.1
Apple: 36 P/E ÷ 5% growth = PEG of 7.2
Amazon: 42 P/E ÷ 12% growth = PEG of 3.5
On a growth-adjusted basis, Tesla's valuation is more defensible than mature tech giants—if you believe the 25% growth continues.
DCF with Multiple Scenarios
| Scenario | Revenue Growth | FCF Margin | Fair Value |
|---|---|---|---|
| Bear (just a car company) | 5% | 5% | $200B |
| Base (EV leader) | 15% | 12% | $600B |
| Bull (autonomy + energy) | 25% | 20% | $1,200B |
Current price ($800B) implies market is pricing in "base +" case: Tesla dominates EVs and achieves moderate success in autonomy/energy. Any disappointment = major downside. Full vision execution = 50% upside.
When to Use Each Method
Use DCF When:
- ✓ Company has predictable cash flows (utilities, consumer staples)
- ✓ You have confidence in long-term projections
- ✓ Company is mature with stable growth
- ✓ You want an absolute intrinsic value (not relative)
- ✓ You have time to build detailed model
Best for: Coca-Cola, Johnson & Johnson, Procter & Gamble, utilities
Use Comparable Companies When:
- ✓ Good comparable companies exist in same sector
- ✓ You need quick valuation check
- ✓ Company is mature/profitable
- ✓ You want to understand relative value vs peers
- ✓ Market is reasonably efficient (not bubble/crash)
Best for: Banks, retailers, most mature industries with clear peers
Use Precedent Transactions When:
- ✓ Evaluating potential acquisition target
- ✓ Industry has active M&A activity
- ✓ You want to understand takeout potential
- ✓ Providing fairness opinion on deal
- ✓ Recent comparable deals exist (within 3 years)
Best for: Biotech, software, consolidating industries
When Valuation Is Most Difficult
- Unprofitable growth companies: No earnings to value, negative FCF
- Unique business models: No good comparables (early Amazon, Uber)
- Cyclical companies: Earnings swing wildly year-to-year
- Disruption situations: Incumbent vs disruptor (Blockbuster vs Netflix)
- Biotechs pre-revenue: Binary outcomes based on clinical trials
Conclusion: The Art and Science of Valuation
Valuation is part mathematics, part judgment. No single method gives you "the answer"—each provides a different lens on value.
Best Practices for Valuation
- 1. Use multiple methods: DCF + Comps + Precedent Transactions = valuation range
- 2. Stress-test assumptions: Run bull/base/bear scenarios
- 3. Understand the drivers: What assumptions matter most? (growth rate, margins, multiples)
- 4. Compare to history: Is company trading above/below historical multiples?
- 5. Margin of safety: Only buy at 20-30% discount to fair value
- 6. Update regularly: Revisit valuation quarterly as new data emerges
You can't predict. You can prepare. Build a valuation range, understand the risks, and demand a margin of safety. That's intelligent investing.
— Howard Marks, Oaktree Capital
Valuation skills separate good investors from great ones. Master DCF for intrinsic value, use comps for relative value, and understand precedent transactions for M&A scenarios. Combined with patience and discipline, proper valuation ensures you buy wonderful businesses at fair prices—the formula for long-term wealth.