Beyond the Basics: Advanced Equity Valuation Techniques!

In the previous articles, we explored the three core equity valuation methods, Relative Valuation, Asset-Based Valuation, and Discounted Cash Flow (DCF). If you haven’t read them yet, here’s the link: How to Derive and Assemble Key Inputs for Discounted Cash Flow (DCF) Valuation! Now that you’re familiar with these foundational approaches, let’s dive into some of the less commonly used but equally important valuation techniques.

While relative valuation, DCF, and asset-based methods dominate mainstream valuation practice, they don’t capture every nuance, especially in complex or uncertain scenarios. To deepen analysis and navigate such gaps, analysts often turn to advanced techniques. Here's a look at four such methods, when to use them, and what to watch out for.

Residual Income Valuation (RIV)
RIV values equity by adding the present value of residual income which is the profits beyond the required return to the current book value. It’s calculated as:
Value = Current Book Value + Present Value of Residual Income
Residual income = (ROE – Cost of Equity) × Prior Book Value.

When to use:
Ideal for firms with unpredictable free cash flows but stable earnings like financial institutions. Useful when dividends are absent or FCF is negative.

Caution:
Highly sensitive to assumptions on ROE and cost of equity. Also depends on clean, conservative accounting.

Real Options Valuation (ROV)
ROV applies financial option theory to strategic decisions like deferring, expanding, or abandoning projects. These are modelled using techniques like Black-Scholes.

When to use:
Useful in industries with embedded flexibility (e.g., oil exploration, biotech, R&D-heavy sectors).

Caution:
Model complexity and assumptions (volatility, timing) are subjective and sensitive. Risk of reduced transparency.

Monte Carlo Simulation
This involves simulating thousands of potential outcomes for key variables (revenues, margins, rates) to produce a value distribution.

When to use:
Best when variables are highly uncertain or path-dependent. Offers probabilistic insights instead of single-point values.

Caution:
Heavily reliant on realistic input assumptions. Poor design leads to misleading outputs.

Sum-of-the-Parts (SOTP)
SOTP breaks a company into business segments, values each separately (via DCF or multiples), and aggregates them, adjusting for debt or central costs.

When to use:
Ideal for conglomerates or companies with unrelated divisions. Helps uncover hidden value or support spin-off arguments.

Caution:
Can mislead if costs or synergies are misallocated. Needs detailed segment data.

In Summary
Each technique has its place. RIV suit stable accounting; ROV and Monte Carlo help in uncertain, strategic cases; and SOTP is essential for complex structures. Mastery lies in choosing the right too, or better yet, triangulating among them to form a robust valuation thesis.

What’s Next?

Now that we’ve covered nearly all major equity valuation methods, you should have a solid grasp of the concepts and be better equipped to apply them in your analysis. In our final article of this Valuation Series, we’ll discuss key considerations to keep in mind while performing any valuation, whether it’s Relative, Asset-Based, DCF, or others. Stay tuned, and feel free to revisit our previous articles in the meantime.