Company Valuation Methods

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Overview

What is this company worth? At today’s price, am I overpaying or getting a bargain?

• Relative valuation:
  • Compare using “multiples”
  • Common: PE (P/E), PB (P/B), PS (P/S)
  • Analogy: checking home prices in the same neighborhood—comparing unit prices rather than pricing every brick and tile
• Absolute valuation:
  • Estimate how much cash the business can generate in the future and discount it back to today
  • The classic method: DCF (Discounted Cash Flow)
  • Analogy: buying a storefront—estimate future rent and discount it to today to see if it’s worth it

• No one relies on a single metric to make decisions
• More commonly: use relative valuation to screen quickly, then use absolute valuation for “deep analysis”
• And then combine: industry traits, company quality, cycle position, and your own risk tolerance

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Relative Valuation

It doesn’t directly answer “what is it worth,” but “expensive/cheap relative to what?”

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PE (Price-to-Earnings)

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1. Definition and calculation

P/E = Share price ÷ Earnings per share (EPS) or: P/E = Market capitalization ÷ Net profit attributable to shareholders

• Trailing P/E: uses the most recently reported full-year net profit (historical)
• Forward P/E: uses expected future earnings (analyst forecasts or your own estimate)
• TTM P/E: uses earnings over the last 12 months (trailing twelve months)

Share price: 20
EPS: 2
→ P/E = 20 ÷ 2 = 10x

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2. Use cases

• Companies with stable earnings and long operating histories
• Examples: mature consumer staples, banks, insurers, mature manufacturing, etc.

• Cross-sectional comparison:
  • Compare P/Es across companies within the same industry (“same track” comparison)
• Time-series comparison:
  • Compare a company’s current P/E to its historical range (“its valuation center”)

• A liquor company historically trades around 18–25x P/E
• Current valuation is 15x and fundamentals haven’t clearly deteriorated → may be “cheap”
• If it rises to 35x while earnings growth is only 10%, it’s clearly “expensive”

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3. Caveats

• High P/E doesn’t necessarily mean expensive:
  • It may reflect a high-growth company with strong future earnings expansion
• Low P/E doesn’t necessarily mean cheap:
  • Earnings may be about to fall, or the industry may be in secular decline
• For cyclicals, look at “cycle-normal” earnings:
  • At the cycle trough, profits are low, so P/E can look extremely high or meaningless
  • At the cycle peak, profits surge, so P/E can look very low—yet risk may actually be higher

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PB (Price-to-Book)

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1. Definition and calculation

P/B = Share price ÷ Book value per share or: P/B = Market capitalization ÷ Shareholders’ equity (net assets)

Book value per share: 10
Share price: 15
→ P/B = 15 ÷ 10 = 1.5x

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2. Use cases

• Asset-heavy sectors, or businesses close to “asset management / asset allocation”
  • banks, insurers, brokerages
  • real estate, some capital-intensive industries

• For these industries, the core is less about “future storytelling” and more about “current asset quality” and “risk control”
• P/B roughly reflects the market’s judgment on asset quality and profitability

• P/B < 1:
  • the market discounts the asset value or expects weak profitability
  • could be an opportunity, or a “value trap”
• P/B significantly above peers:
  • may imply better asset quality, stronger profitability, better governance

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3. Caveats

• Book value is not the same as “replacement cost”: accounting measures can differ from economic value
• For asset-light, high-tech, internet businesses, P/B is less informative:
  • real value is often in “technology, brand, users, data,” and other intangibles
  • many great companies have low book value but enormous long-term value

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PS (Price-to-Sales)

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1. Definition and calculation

P/S = Market capitalization ÷ Revenue or: P/S = Share price ÷ Revenue per share

Market cap: 10B
Revenue (last year): 2B
→ P/S = 10 ÷ 2 = 5x

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2. Use cases

• Companies with unstable profits or not yet profitable, but with fast revenue growth
• Typical: internet, SaaS, platforms, early-stage high-growth companies

• Early on, companies invest heavily in customer acquisition and R&D, depressing profits or causing losses
• P/E becomes unusable or distorted; revenue better reflects scale and growth potential

• Look at the combination of revenue growth + P/S, not P/S alone
  • e.g., 50% revenue growth with 10x P/S
  • if growth drops to 10% but P/S stays 10x, valuation risk rises sharply

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3. Caveats

• Revenue growth is not the same as profit growth:
  • if unit economics are poor or margins are negative, high revenue alone may mean little
• “Fair” P/S varies hugely by industry—compare within the same category
• Best for estimating “ranges,” not as a standalone buy/sell trigger

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Absolute Valuation

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DCF (Discounted Cash Flow)

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1. Core logic

A company’s value = the sum of all future free cash flows it can deliver to shareholders, discounted back to today.

1. Future cash flows (CF):
   • usually “free cash flow to equity” or “free cash flow to the firm”
   • operating cash generated minus maintenance/necessary capital expenditures
2. Discount rate (r):
   • the required return for investing in the company
   • related to the risk-free rate, risk premium, industry risk, etc.
3. Terminal value (TV):
   • the long-term value after the explicit forecast period
   • often estimated via a “perpetual growth” model

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2. Simplified formula (illustration)

Value = CF₁ / (1+r)¹
      + CF₂ / (1+r)²
      + CF₃ / (1+r)³
      + CF₄ / (1+r)⁴
      + CF₅ / (1+r)⁵
      + TV / (1+r)⁵

Where:
TV = CF₅ × (1 + g) ÷ (r - g)

• Are your cash flow assumptions reasonable?
• Does the discount rate match the company’s risk level?
• Is the terminal growth assumption too optimistic (g cannot exceed the economy’s long-run growth by too much)?

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3. A simple analogy

• You expect 100K in rent per year
• You require at least an 8% annual return
• Rent rises slightly over time (say 2%)

• Given this rent level and growth, what’s the maximum I’m willing to pay for the storefront?
• DCF does the same—just replacing the “storefront” with a “company.”

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4. Pros and cons of DCF

• Pros:
  • Theoretically closest to “intrinsic business value”
  • Systematically incorporates growth, profitability, investment spending, capital structure, etc.
• Cons:
  • Extremely sensitive to assumptions (growth, margins, discount rate, terminal value)
  • Small parameter changes can double or halve the valuation
  • Requires deeper business understanding and financial modeling skill

• DCF often serves as a long-term “anchor”,
• while PE/PB/PS are used for:
  • quick comparisons, gauging market sentiment, and judging whether valuation looks rich/cheap in relative terms.

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Core Concepts

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1. Price vs. value

• Price: the market’s real-time quote, driven by sentiment and flows
• Value: an estimate of intrinsic value based on future cash flows and asset quality

• the market is like a voting machine—whoever has more votes wins In the long run:
• the market is like a weighing machine—the company’s “weight” (real earnings and cash flow) matters more

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2. Margin of safety

• If you believe “fair value” is roughly 20–25
• A truly attractive buy price might be 18 or lower

• Price materially below your conservative intrinsic estimate
• A high-quality business with strong resilience

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3. Matching growth with valuation

• High-growth companies can often justify higher valuation multiples
• Low-growth or negative-growth companies may not be cheap even if multiples look low

• A company sustaining 20%+ long-term growth may not be expensive at 30–40x P/E
• A company growing only 5% may already be pricey at 20x P/E

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4. Matching valuation methods to business models and industry traits

• Asset-heavy, stable-profit industries: PE and PB tend to work better
• High-growth, asset-light, early-loss industries: PS + DCF matter more
• Strong cyclicals: use “normalized earnings” or “cycle-center valuation,” not just current P/E

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Practical Applications

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Case 1: A mature consumer company — PE + PB

• Revenue has grown steadily at 8%–10% over the past 5 years
• Gross margin is stable, and net margin stays around 15%
• Operating cash flow roughly matches net profit, and dividends are stable

1. Check historical valuation ranges:
   • Over the past 5 years, P/E mostly ranged 18–25x, and P/B 3–4x
2. Check current valuation:
   • Current P/E ~ 17x, P/B ~ 2.8x, slightly below its historical center
3. Synthesize:
   • No obvious signs of industry decline
   • Competitive position is stable
   • Valuation is modestly discounted → may be an opportunity within the value range

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Case 2: A high-growth internet company — PS + DCF

• Revenue grows 40% YoY, but the company is still loss-making
• Marketing and R&D investment “eat” most profits

1. P/E is basically unusable (losses or highly unstable profits)
2. Start with P/S for relative positioning:
   • vs peers: peer average P/S is 6–8x; the company you watch is at 5x
3. Then run a simplified DCF:
   • Assume revenue growth slows over the next 3–5 years
   • Gross margin and expense ratios gradually converge toward mature-company levels
   • Estimate free cash flow over the next 5–10 years
4. Arrive at a “valuation range” and judge whether current price offers enough margin of safety

• Valuation swings can be large and forecasting uncertainty is high
• It fits investors who can tolerate higher volatility

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FAQs

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Q1: Does a high P/E mean I should never buy?

• Is the high P/E driven by:
  • euphoric market sentiment?
  • or highly certain, high-quality growth over the next few years?
• If earnings can compound at 30%–40% for several years and P/E is only 25–30x,
  • it may still be attractive with a reasonable margin of safety
• Conversely, if a company is mature with low growth but trades at 40x P/E, beware of “great company, bad price.”

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Q2: Different valuation methods give very different answers—what should I trust?

1. Treat different methods as “measurements from different angles”:
   • P/E: how the market prices your earnings
   • P/B: how the market prices your book equity
   • P/S: how the market prices your scale/revenue
   • DCF: your intrinsic estimate from a cash-flow perspective
2. Focus on understanding “why the difference exists”:
   • different growth assumptions?
   • different views on margins/cash flow quality?
   • different discount rates and risk judgments?
3. Ultimately, build your own valuation range and margin of safety rather than blindly trusting any single “precise number.”

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Q3: For IPOs or loss-making companies, what if P/E can’t be calculated?

• Start with business model and industry runway:
  • does the business have long-term logic? is the market large enough?
• Then use:
  • P/S to compare with peers
  • simplified DCF with scenarios (bull/base/bear)
• Don’t get carried away by storytelling:
  • if the company can’t even explain the quality of revenue growth and only talks about a grand future, be cautious

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Summary

• Valuation methods broadly fall into:
  • Relative valuation: use multiples like P/E, P/B, P/S to compare with history and peers
  • Absolute valuation: use DCF to estimate discounted future cash flows
• No method is “uniquely correct.” What matters is:
  • whether the method matches the company stage and industry traits
  • whether assumptions are reasonable and conservative
  • whether you have enough margin of safety
• Practical suggestions:
  • use P/E/P/B/P/S to quickly judge the rough “rich/cheap” zone
  • for important positions or long-term holds, validate with a simplified DCF
  • treat valuation as a tool to understand business and market expectations, not a pure arithmetic exercise

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Further Reading

• Security Analysis — Benjamin Graham & David Dodd
  • The classic starting point for value investing and valuation thinking
• The Intelligent Investor — Benjamin Graham
  • The source of core ideas such as margin of safety and Mr. Market
• Aswath Damodaran’s books (e.g., Investment Valuation, The Little Book of Valuation)
  • Systematic coverage of DCF, multiple valuation models, and valuing different types of companies
• High-quality brokerage / investment bank deep-dive reports on individual stocks
  • Practical templates combining “valuation modeling + company understanding,” helping you apply theory to real cases