Key Considerations Across Equity Valuation Methods!

In the previous article, we explored several less commonly used equity valuation methods that are applied in specific situations where they are most suitable. If you haven’t read it yet, here’s the link: Beyond the Basics: Advanced Equity Valuation Techniques! In this article, we’ll focus on the key considerations to keep in mind while performing any valuation, ensuring your results are accurate and reliable.

When it comes to valuing a company’s equity, there is no universally best method. Each valuation approach, whether based on comparables, assets, future cash flows, or more advanced models like real options or Monte Carlo simulations, has its own set of assumptions, strengths, and limitations. Therefore, a thorough and credible valuation often involves comparing multiple methods, testing key inputs, and reconciling results to form a well-rounded view.

Relative Valuation uses market-based ratios like P/E, EV/EBITDA, or P/B to value a company based on peers. Success in this method depends on choosing comparable firms with similar size, industry, and capital structure. The ratios selected must be appropriate for the sector, for example, P/S for early-stage tech firms. Analysts must adjust for one-time items to ensure consistency and remain mindful that investor sentiment is embedded in the multiples, sometimes leading to misleading conclusions.

Asset-Based Valuation values a company’s equity by calculating the fair market value of its assets minus its liabilities. This method is more applicable to asset-heavy or distressed firms. Key adjustments include revaluing assets like property or intangibles and incorporating off-balance-sheet obligations like leases or pension liabilities. Depending on whether the company is a going concern or a liquidation candidate, the approach will differ.

Discounted Cash Flow (DCF) remains a cornerstone of intrinsic valuation. It estimates a company’s value based on its projected free cash flows, discounted at an appropriate rate. However, since a large portion of value often lies in terminal assumptions, careful forecasting and alignment of discount rates with cash flow types (FCFF vs. FCFE) are essential. Analysts should also account for future changes in capital structure and use sensitivity analysis to understand how changes in key drivers affect valuation.

Residual Income Valuation (RIV) builds on DCF by adding the present value of future income that exceeds the required return on equity to the firm’s book value. It requires confidence in the quality of accounting figures and accurate estimation of the cost of equity.

Real Options Valuation (ROV) incorporates strategic flexibility into valuation. Companies may have the option to expand, defer, or abandon projects, and valuing this flexibility, using models like Black-Scholes or binomial trees—adds depth to traditional DCF analysis.

Monte Carlo Simulations add probabilistic modelling to the mix, especially when input variables are uncertain. By running thousands of trials, analysts can capture a range of possible outcomes, improving risk assessment.

Sum-of-the-Parts (SOTP) valuation is useful for diversified businesses. It values each business unit separately using the most suitable method and aggregates them, net of debt and non-core items.

Ultimately, combining multiple valuation methods and applying informed judgment leads to a more balanced and defendable equity valuation.

What’s Next?

This brings us to the end of the valuation series we began earlier this month. Stay tuned as we move on to our next article, whether it's part of a new series or a standalone piece, each one will offer you fresh insights and valuable learning.