Valuation Approaches
What is tested
Converting forecasts into an intrinsic or relative value, and knowing when each method is appropriate.
Intrinsic methods
- FCFF discounted at WACC: FCFF = EBIT(1 − t) + depreciation − capex − increase in working capital. Firm value = PV(FCFF) + PV(terminal value); subtract net debt for equity value.
- FCFE discounted at cost of equity: appropriate when leverage is stable and dividends do not reflect capacity to pay.
- Terminal value: Gordon growth TV = FCFFn+1 / (WACC − g), or an exit multiple. g cannot exceed long-run nominal GDP growth.
Dividend discount model
Gordon: P0 = D1 / (r − g), where D1 = D0(1 + g) and g = retention ratio × ROE. Requires g below r.
Relative valuation
- P/E: trailing versus forward; distorted by one-offs and accounting differences.
- P/B: useful for banks and asset-heavy firms; justified P/B = (ROE − g)/(r − g).
- EV/EBITDA: capital-structure neutral; EV = market cap + debt − cash (+ minority interest + preferred).
- PEG, P/S and dividend yield as cross-checks.
Worked example
D0 = ₹8, payout ratio 40%, so retention b = 60% and g = 0.60 × 15% = 9% on an ROE of 15%. Cost of equity r = 13%. D1 = 8 × 1.09 = ₹8.72. P0 = 8.72 / (0.13 − 0.09) = ₹218. The share trades at ₹180, a 17% discount. But the model is sensitive: at r = 14%, P0 = 8.72/0.05 = ₹174, close to the market price. The analyst reports ₹218 as a base case, runs the sensitivity, and does not declare the stock undervalued until the cost-of-equity assumption is defended.
Traps
Discounting FCFE at WACC; using D0 instead of D1; setting g above r or above nominal GDP growth; comparing P/E across firms with different growth or leverage; using EV/EBITDA when EBITDA is negative; ignoring dilution and option proceeds in EV.