Choosing the right valuation method!

In the previous article, we talked about what is valuation, why it’s important and looked at its different types. If you haven’t read that already, here’s the link: Everything you need to know about Equity Valuation!   Now in this article we’ll look at the how one should think about choosing the right equity valuation method and what factors to consider.

Why choosing the right method is important?

Choosing the right valuation method is crucial because different businesses have different financial characteristics, risk profiles, and industry dynamics. A method suitable for a mature, cash-generating company may not work for a startup or asset-heavy firm. The appropriate approach ensures more accurate, relevant, and context-specific valuation outcomes, supporting informed investment decisions.

Intrinsic Valuation

Intrinsic valuation, particularly the Discounted Cash Flow (DCF) method, is ideal when a company has stable and predictable future cash flows. It estimates a business's value based on projected cash flows, discounted back to present value using a risk-adjusted rate. This method is most effective for mature companies with reliable earnings histories, such as utilities, Large-Cap tech firms, or established industrial players. 

Choose DCF when long-term fundamentals matter more than market sentiment such as during strategic planning, M&A, or internal financial assessment. However, accuracy depends on the reliability of cash flow projections and discount rate assumptions. Key factors to consider include revenue visibility, margin stability, capital structure, growth prospects, and sensitivity to macroeconomic conditions because all these factors will either increase or decrease the valuation.

Relative Valuation

Relative valuation is chosen when you want a market-driven assessment of a company’s worth by comparing it to similar firms. It’s especially useful in sectors with many listed peers and when cash flow projections are uncertain or hard to model, such as for high-growth or early-stage companies. This method is faster, simpler, and reflects current market sentiment.

It is best used when the company operates in a well-defined industry, has comparable peers, and there's enough data for meaningful comparisons using metrics like P/E, EV/EBITDA, P/B or P/S, etc.

Key factors to consider in relative valuation include the availability and reliability of comparable companies, consistency in accounting practices, and similarity in business models and growth trajectories. It’s also important to account for prevailing market conditions, investor sentiment, and any temporary distortions or outliers that may skew valuation multiples.

While efficient and widely used, relative valuation relies heavily on the accuracy of peer group selection and may not reflect intrinsic value.

Asset Based Valuation

Asset-based valuation is ideal for companies with substantial tangible assets or unpredictable earnings, such as real estate firms, manufacturers, holding companies, or distressed businesses. It involves valuing a company by subtracting liabilities from the total value of its assets, often reflecting liquidation or replacement value. This approach is preferred when stable cash flows are absent, peer comparisons are limited, or the business is being sold or restructured.

Key considerations include asset valuation accuracy, hidden liabilities, depreciation, and whether to apply book or market values. However, this method may undervalue firms with strong growth potential or significant intangible assets, like tech companies.

What’s Next?

Now that we have a decent understanding of the basics of valuation and knowing when to use which valuation method, we can now dive deeper into each of the valuation methods, so stay tuned as we work on the next article.