Stock Valuation Methods and Intrinsic Value Analysis
Stock valuation attempts to determine a company's intrinsic value—the theoretical fair price based on fundamental business factors rather than current market sentiment. Multiple valuation approaches exist, each with strengths and limitations depending on company characteristics, industry dynamics, and available information. The most common methods include discounted cash flow (DCF) analysis, relative valuation using multiples, and dividend discount models (DDM).
Discounted cash flow analysis values a company based on projected future cash flows discounted to present value using an appropriate cost of capital. This intrinsic valuation method requires forecasting future cash flows (typically free cash flow to equity or to the firm), estimating a discount rate (using CAPM or WACC), and calculating a terminal value for cash flows beyond the explicit forecast period. DCF analysis is theoretically sound but highly sensitive to assumptions about growth rates, margins, and discount rates—small changes in inputs can dramatically affect calculated values.
Relative valuation uses market-based multiples to compare companies against peers or historical norms. Common multiples include price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), and enterprise value-to-EBITDA (EV/EBITDA). Each multiple has appropriate use cases: P/E works well for mature, profitable companies; P/S is useful for unprofitable growth companies; EV/EBITDA allows comparison across different capital structures. The key is selecting comparable companies with similar growth prospects, risk profiles, and business models.
The dividend discount model values stocks based on the present value of expected future dividends, with the Gordon Growth Model (a constant-growth version) being most common. DDM works best for mature companies with stable dividend policies but struggles with non-dividend-paying growth stocks. For those situations, analysts often use two-stage or multi-stage models that assume high growth initially before transitioning to sustainable long-term growth rates.
Practical stock valuation combines multiple approaches to triangulate reasonable value ranges rather than relying on single point estimates. No valuation model perfectly captures all relevant factors—market conditions, competitive dynamics, management quality, and future innovation all affect intrinsic value but resist precise quantification. The margin of safety concept, popularized by Benjamin Graham, suggests buying only when market price sits substantially below calculated intrinsic value, providing a buffer against estimation errors and unforeseen negative developments.