A stock is a claim on a business, and businesses can be valued — imperfectly, but usefully. Valuation gives you an independent estimate of what a company is worth, so you can compare it to what the market is charging. Without one, you're only guessing whether a price is high or low, and the market is happy to let you guess.
Two big families of methods dominate. Intrinsic methods, like discounted cash flow, build value from a company's own future cash. Relative methods, like comparable company analysis, infer value from what similar businesses trade for. Most professionals use both and treat the answers as a range, not a bullseye.
The DCF method rests on one idea: a dollar next year is worth less than a dollar today. If your required return is 10%, then $110 arriving a year from now is worth $100 right now. A DCF applies that logic to a whole business — project its future free cash flows, discount each one back to present value, and add them up.
In practice you forecast cash flows for five to ten years, then calculate a terminal value for everything beyond that, using a discount rate that's typically the weighted average cost of capital, or WACC. If the resulting value per share is well above the current stock price, the stock may be undervalued. Small changes in assumptions can swing the answer dramatically, which is both the method's greatest strength and its greatest weakness — it forces you to make your assumptions explicit.
Say a company generates $100 million of free cash flow, and you expect 5% growth for five years, then 2% forever. Your discount rate is 10%.
Year one's cash flow is $105 million; discounted back one year, it's worth about $95 million today. Repeat for each year and the five discounted flows sum to roughly $436 million. Then comes the terminal value: year six's cash flow of about $130 million, divided by the discount rate minus the long-term growth rate (10% minus 2%, or 8%), gives roughly $1.63 billion — worth about $1.01 billion in today's dollars. Total value: about $1.45 billion. With 100 million shares outstanding, that's roughly $14.50 per share.
Notice something uncomfortable: about 70% of the value came from the terminal value — the part you know least about. That's normal, and it's why thoughtful analysts test several growth and discount assumptions instead of trusting one number.
Comparable analysis values a company by lining its valuation multiples — P/E, EV/EBITDA, price-to-sales — up against similar companies in the same industry. The logic is simple: similar businesses should trade at similar multiples, so a company priced well below its peers deserves a closer look, and so does one priced well above.
The hard part is choosing truly comparable peers. Two companies in the same industry can have very different growth rates, margins, and risk. A fast grower deserves a higher multiple than a shrinking rival, so a naive comparison can mislead. Even so, comps are the most widely used valuation method on Wall Street, because they're fast, practical, and grounded in real prices people are actually paying.
A P/E of 20 means you're paying $20 for each $1 of annual earnings. Flip it over and you get an earnings yield of 5% — a rough sense of what the business earns on your purchase price today. That's why high-growth companies command high P/E ratios: buyers are paying for earnings they expect tomorrow, not the ones printed today.
Different multiples suit different situations. EV/EBITDA includes debt in the price, so it's fairer for comparing companies with different borrowing levels. Price-to-sales helps with young companies that aren't yet profitable, though it says nothing about whether profits will ever arrive. Whatever multiple you use, compare within an industry, and ask why a gap exists before assuming it will close.
Every valuation is a set of guesses dressed in math. Change a DCF's growth rate from 5% to 7%, or its discount rate from 10% to 9%, and the answer can move by a third. That doesn't make valuation useless — it makes false precision dangerous.
Two habits protect you. First, build a range: value the business under pessimistic, base, and optimistic assumptions, and see where today's price falls. Second, insist on a margin of safety — only act when price sits comfortably below even your cautious estimate, so being somewhat wrong doesn't hurt much. Nobody values a business exactly right. The goal is to be roughly right, with enough cushion that roughly is good enough.
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