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Valuation Methods

When it comes to valuing a company, there are two classes of methods you can choose from;

  • Intrinsic Valuation

These methods find the true core value of a company, and there’s two forms;

  • Relative Valuation (Multiples)

This method determines the value of a company relative to similar companies in today’s stock market, so it reflects what a stock will be priced at rather than what it’s inherent value is, and here we have two ways to do this;

  • Free Cash Flow Multiples – using multiples of the free cash flow, which is used for companies which are free cash flow positive.
  • Sales Multiples – using multiples of sales, which is used for companies which are free cash flow negative.

The main difference between discounted cash flow (DCF) analysis and multiples (relative valuation) is this – multiples are dependent on the stock market whilst DCF is not. Multiples can change significantly based on superficial factors. For example, when the overall stock market is healthy, multiples are high across the board. When investors love a particular industry or sector, the multiples of all those companies rise. However, the opposite can also happen, with an unhealthy stock market and bad investor sentiment towards an industry causing multiples to drop. So if you use multiples to value a company, you may be using high multiples whilst the stock market is healthy or an industry is booming. This will lead you to put a high value on the company, which in turn will give you a high calculated stock price, and you’ll then buy the stock at that high price. If investor sentiment changes towards that industry, or the stock market becomes unhealthy, your stock could fall well-below what you paid for it and never return. Essentially, multiples can jump all over the place, so with multiples, it’s easier to lose money – especially if you don’t use a margin of safety which you’ll learn about in step 3.

On the other hand, our intrinsic valuation methods calculate the true core value of a company, and while a stock may temporarily fall below this number, in the long-run the stock will end up somewhere near to this value. So if you use intrinsic valuation methods to calculate the value of a stock, and you only buy stocks when they’re at or below this calculated number, then you will essentially never lose money. In the long run, a stock will always end up somewhere near to its intrinsic value – it’s true core value. The reason behind this is complicated but if you’re interested, then Google search ‘intrinsic valuation’.

So the path you wish to pursue is up to you – I’ve only thrown this in here just for your awareness of the differences. At the end of the day, nearly every investor out there uses multiples (relative valuation) to value a company – only the core die-hard value investors exclusively use intrinsic valuation. However, the most sure-fire way to succeed consistently is to rely on your intrinsic methods rather than your relative methods, especially in today’s stock market which is ridiculously over-valued and unsustainable.