Lesson 9: Valuing Companies – An Overview of Methods
Value Investing 101: Introductory course
In the previous lesson, we discussed the importance of intrinsic value and why it should be the compass for every value investor. In this lesson, we’re going one step further. We won't dive into complex calculations, but will take the time to lay out the different valuation methods side by side.
As with any craft, investing requires choosing the right tools for the right situation. Some methods are ideal for stable companies with predictable earnings, others are better suited to cyclical sectors or young growth firms.
We’ll dive a bit deeper into the Discounted Cash Flow method and Relative Valuations. For the other methods, the goal is simply that you're familiar with them so you can explore further on your own.
This is not a valuation course. The goal of this lesson is understanding, not perfection. You don't need to be a specialist in deciphering Excel models—what we want to achieve is helping you think critically about how valuation works, and what that means for your decisions as an investor.
1. The Discounted Cash Flow Method (DCF)
— A rational approach, but not an exact science
As a value investor, you only want to buy something if you’re paying less than it's worth. Sounds simple, but it requires discipline and a well-founded valuation method.
The most commonly cited way to calculate a company's value is the DCF (Discounted Cash Flow) method. This approach attempts to determine the value of a company based on all future free cash flows, brought back to their present value.
DCF is mathematically sound. Perfect in theory. But in practice, it is often misused, incorrectly applied, or used with too much confidence in questionable assumptions.
What exactly is DCF?
DCF is based on one simple idea:
The value of a company is equal to the sum of all future cash flows, discounted to today.
Or as Buffett put it at the 2009 annual meeting:
“The question is: how many birds are in the bush? What’s the discount rate? How sure are you that you’ll get them?”
So with DCF valuation, you’re not just adding up what a company earns. You’re looking at how much cash it will generate, when, and how certain you are of that. Then you calculate what all of that is worth today using a discount rate.
The Basic Formula
Conceptually, the DCF formula looks like this:
📌 Company Value = ∑ [Free Cash Flow in year t / (1 + r)^t] + Terminal Value / (1 + r)^n
Where:
r = discount rate (your required rate of return)
n = number of years in the forecast
Terminal Value = the value of the company after that period
You add the discounted value of free cash flows over the coming years, and then add the present value of the terminal value.
Three Crucial Inputs in DCF
A DCF analysis completely depends on three variables:
Free Cash Flow (FCF) growth
Discount rate (r)
Terminal growth rate (g)
Let’s go through them one by one.
1. Estimating Future FCF Growth
Free Cash Flow (FCF) = Cash flow from operations – Capital expenditures (capex)
Usually, you start with the average FCF from the last 3 years, then estimate how much it will grow each year. This is where the biggest risk of overestimation lies.
A classic approach is to use two phases:
Phase 1: first 5 years: moderate growth (e.g. 5% – 15%)
Phase 2: years 6 to 10: slowing growth (e.g. 3% – 7%)
💡 Be conservative.
Don’t assume 20% growth for 10 years unless you’re analyzing a truly exceptional company. For most businesses: if they seem undervalued with a conservative 5% growth rate, you’ve likely found something good.
Note: Don’t blindly use historical averages. Past = guide, not compass.
2. Discount Rate: Your Required Return
The discount rate (r) reflects your required return and is often used as a measure of risk. The higher the risk, the higher the rate you should apply.
In theory, you’d use the CAPM model—but in practice, we advise against that. Better to use common sense and a simple return perspective.
Rules of Thumb:
Safe, stable companies (e.g. Unilever, Heineken) → 8% – 10%
Mid-sized companies → 12% – 14%
Small or risky companies → 15% or more
Think of your discount rate as your personal “interest rate.” What’s the minimum return you want to earn on this stock, given the risk? That is why I rarely go below 10%
3. Terminal Value – Growth Rate into Infinity
After the explicit forecast period (usually 10 years), you assume the company will continue to exist. But at what growth rate?
📌 Keep this low — preferably between 0% and 2%.
More than 3% implies the company grows faster than the global economy, which isn’t sustainable.
Buffett’s approach is clear: “Set it at 0% if you’re unsure.”
The terminal value often accounts for more than 50% of your calculated company value. Overestimating = overvaluing.
Why DCF Is Hard in Practice
Even though DCF seems logical, here’s the paradox:
You need to predict the future to know present value — but the future is by definition unpredictable.
Even small changes in your assumptions can massively impact the outcome. See below:
A shift of just 1–2% in your inputs can change the value by tens of percent.
The Solution? Margin of Safety
Because all valuations have errors, you need to protect yourself. Do that by building in a margin of safety: only buy if the price is well below your calculated value.
Example:
You calculate an intrinsic value of €100?
👉 Only buy if the stock is trading at €60 or less.
This protects you from:
Overly optimistic assumptions
Unexpected events
Modeling or calculation errors
As Benjamin Graham said:
“The three most important words in investing? Margin of Safety.”
Where DCF Is Actually Useful
A well-used DCF won’t tell you exactly what a company is worth, but it will tell you:
✅ What assumptions are needed to justify the current price?
✅ How much growth is already priced in?
✅ What is my potential return if my assumptions are right?
Use DCF as a reverse exercise too: input the current share price as the output, and calculate what growth would be needed to support it.
If that means 15% annual FCF growth for 10 years, you’ll know the stock has high expectations baked in.
Final Warning
Don’t get caught up in the idea of “precision.” As Charlie Munger said:
“Some of the worst decisions come from very precise models.”
DCF is an estimate, not an absolute truth. Think of it as a thinking framework, not a truth machine.
2. Residual Earnings Method (RE)
What is it?
Instead of focusing on free cash flows, this method looks at profits above the expected return on equity (book value). The formula compares ROE with a required return (e.g. 10%).
When to apply?
Companies with negative FCF but positive profits
Capital-intensive sectors where growth requires significant investment
Advantages:
Less sensitive to terminal value than DCF
Based on accounting figures, which are more reliable in the short term
Helps you quickly estimate the “speculative component” in a stock price
Disadvantages:
Still depends on forecasts (though only for 2–3 years)
More complex for beginners to understand
Accounting profit can be manipulated and needs adjustments
A crucial angle with RE: How much speculative growth is already priced in? This helps you better understand what Mr. Market is asking of you.
Usage Tips:
Use RE to reverse-engineer market expectations
Focus on companies where “speculative value” is limited
Compare RE outcomes with DCF or EPV for consistency
3. Earnings Power Value (EPV)
What is it?
EPV doesn’t start with future growth. Instead, it looks at current earnings power and assumes it stays constant. No future predictions—just corrections to the present.
When to apply?
Stable businesses with some cyclicality
Companies where earning power can be reliably estimated
Advantages:
Very conservative and realistic
No need for speculative growth assumptions
Great for identifying whether a company has a moat (sustainable competitive advantage)
Disadvantages:
Ignores growth—which may not always be appropriate
Not useful for young growth companies or rapidly changing businesses
Requires adjustments to financial statements (for exceptions, R&D, marketing, etc.)
EPV is the perfect starting point for estimating what a company is worth today. Growth is a bonus—but not required with this approach.
Usage Tips:
Use EPV alongside asset reproduction value to identify a moat
Treat the result as your base case—growth comes afterward
4. Relative Valuation Methods
— Simple comparisons that can be powerful… if used correctly
In the previous sections, we discussed valuation methods that start from the company itself—via cash flows, earnings power, or book value. These are absolute valuations, aiming to determine a company's worth independently of the market.
Relative valuation methods take a different approach.
They don’t ask:
What is this company intrinsically worth?
But rather:
How does this company compare to similar companies?
These methods don’t focus on the company’s actual value, but on the price the market pays for similar companies. That’s why they’re also called market-driven valuations.
What are relative valuations?
They use a simple ratio:
📌 Price of a share / Financial metric
Examples:
Price / Earnings (P/E)
Price / Book Value (P/B)
Price / Sales (P/S)
Price / Cash Flow (P/CF)
EV / EBIT or EV / EBITDA
These ratios are then compared with peers, historical averages, or market benchmarks to determine whether a stock is “expensive” or “cheap” in relative terms.
Why are they so popular?
➡️ Because they’re fast and easy to use
➡️ Because the data is widely available
➡️ Because analysts and fund managers are often judged on relative performance
Research shows that up to 85% of stock recommendations on Wall Street use relative valuation.
But simplicity comes with traps. Relative valuations seem objective, but often aren’t. They depend on market mood and errors.
As a former fund manager once said:
“If you're going to screw up, do it with enough others.”
The Most Important Ratios – Overview
We’ll now review the most common relative valuation ratios, with:
What do they measure?
When are they useful?
What are their pros and cons?
How to use them correctly?
I. Price / Earnings (P/E or K/W)
What is it?
P/E = Share price / Earnings per share (EPS)
Example:
Price = €120, EPS = €10 → P/E = 12
P/E shows how many years it takes to earn back your investment via profits (assuming earnings stay flat).
When is it useful?
For profitable companies with stable earnings
When comparing companies within the same sector
Pros:
Simple and intuitive
Widely used, so easy to benchmark
Gives a rough idea of valuation
Cons:
Profit is accounting-based and can be manipulated
Ignores debt or cash on the balance sheet
Hard to use for cyclical or unprofitable companies
P/E without context is meaningless (is 25 high or low?)
💡 Use average earnings over the last 3–5 years to smooth out cycles, as Graham advised.
II. PEG Ratio (Price/Earnings to Growth)
What is it?
PEG = P/E divided by expected annual earnings growth (%)
Example:
P/E = 15
Expected growth = 10%
PEG = 1.5
Peter Lynch liked PEG < 1, and found PEG > 2 risky.
When is it useful?
For growth stocks where a high P/E might be justified
When you want to factor growth into valuation
Pros:
Connects valuation to growth potential
Helps distinguish expensive vs “growth-expensive” stocks
Cons:
Based on estimated growth — prone to errors
Ignores risks or the quality of growth
One-year growth estimates are often too narrow
💡 Use PEG as a rough sanity check, not a deciding factor.
III. Price / Book Value (P/B)
What is it?
P/B = Share price / Book value per share
Example:
Price = €40
Book value = €20 → P/B = 2
Book value = Assets – Liabilities
When is it useful?
Financial institutions
Cyclical sectors or turnarounds
Capital-intensive companies
Pros:
Simple, especially for asset-heavy businesses
Historically favored by deep value investors
Cons:
Book value often outdated or inaccurate
Less relevant for service-based companies
Ignores intangible assets and brand value
💡 Best used as part of a broader analysis (e.g. combined with ROE).
IV. EV / EBIT and EV / EBITDA
What is it?
EV (Enterprise Value) = Market cap + Net debt
EV/EBIT = Company value compared to operating profit
EV/EBITDA = Company value compared to operating profit before depreciation and amortization
When is it useful?
For companies with different capital structures
For comparisons within capital-intensive sectors
Pros:
Includes debt and cash positions
Less manipulable than EPS
Suitable for comparing different companies
Cons:
EBIT or EBITDA can still be manipulated
EBITDA ignores capital expenditures — misleading for investment-heavy businesses
Not ideal for banks or insurers
💡 EV/EBIT is more robust than P/E because it’s unaffected by financing structure.
V. Price / Sales (P/S)
What is it?
P/S = Share price / Revenue per share
Example:
Revenue per share = €100
Price = €50 → P/S = 0.5
When is it useful?
Start-ups or growth companies without profits
Cyclical companies in a downturn
Pros:
Revenue is harder to manipulate than profit
Always positive (unlike net income)
Cons:
Says nothing about profitability
Needs to be interpreted alongside profit margins
💡 Use for early-stage growth companies, but always combine with gross margin analysis.
Relative Valuations: Summary Table
How to Use Relative Valuation Properly
✅ Only compare similar companies
→ Same sector, size, and growth profile.✅ Use consistent “E” in P/E
→ Use trailing 12 months (TTM), fiscal year, or 3-year average. Not mixed!✅ Combine with fundamental analysis
→ Relative valuation tells you nothing about cash flow, debt, or business quality.
✅ Be cautious with high multiples
→ A P/E of 50 demands extraordinary growth and reliability.✅ Use multiple ratios together
→ P/E + EV/EBIT + P/B together give a fuller picture.
In Conclusion
Relative valuations are like a compass at sea: they show where other ships are heading, but not whether your destination is correct. They can help you stay on course, but you have to decide if the direction is right.
Use these ratios as filters, not as foundations. Apply them with context, common sense, and always alongside your own analysis of the company.
Ultimately, relative valuations work best as a supplement to absolute valuations — not as a replacement.
5. Other Methods – Briefly Discussed
a. Benjamin Graham Formula
Graham proposed a simple formula:
Value = EPS × (8.5 + 2 × growth rate)
Mainly intended for stable companies. Now outdated, but still usable as a rule of thumb.
b. Net Asset Value (NAV) or Liquidation Value
Valuation based on assets – especially useful for holding companies, banks, or distressed businesses.
c. Dividend Discount Model (DDM)
Suited for companies that pay stable and predictable dividends. Less useful for growth firms or those with fluctuating payout policies.
Final Thoughts: What Now?
No method is perfect. Each approach has its place, depending on the type of company, industry, stability, and your own expertise.
For growth companies, use DCF — but scrutinize the terminal value.
For capital-intensive businesses, the residual earnings method works well.
For stable companies with predictable profits, EPV offers a strong baseline.
For quick comparisons or screening, multiples like P/E and EV/EBIT are handy — but not enough on their own.
“Don’t invest in a company just because a model says it’s undervalued. Invest because you understand why the model is suggesting something interesting.”
Investing isn’t about perfection — it’s about probability.
Valuation is your tool for assessing opportunities — not for finding certainty.
Value Investing 101: beginner friendly course
In the current market situation, I believe it's time to create an introductory series on value investing—a method that focuses on buying businesses at a price lower than their true value.