Introduction to Valuation

What is a company truly worth? 

This is arguably the most fundamental question in finance. The price you see flickering on a stock exchange is what someone is willing to pay for a single share right now, but its underlying, or intrinsic value, may be something else entirely. 

Valuation is a fascinating blend of art and science. The "science" lies in the financial models, the rigorous calculations, and the established formulas. The "art" lies in the assumptions we make, the stories we tell about a company's future, and the nuanced interpretation of the final numbers. The answer is never a single, definitive number. Instead, valuation provides a compass, not a GPS pin. It offers a range of reasonable value based on a set of assumptions, future expectations, and comparable benchmarks.

The Philosophical Bedrock: Price vs. Value

Before we crunch a single number, we must internalize a crucial distinction: value is not the same as price.

• Price is what you pay. It’s a transient, observable fact set by the market's whims, sentiments, and liquidity at a given moment. It’s the number on the stock ticker.

• Value is what you believe you are getting. It is an intrinsic estimate of the company's worth based on its ability to generate cash flows for its owners over its lifetime.

The goal of valuation is to identify the gap between price and value. When calculated value significantly exceeds market price, you may have found an opportunity (a potential “buy”). When price far surpasses value, it may be time to sell or avoid. 

This discipline is the bedrock of value investing, famously championed by Benjamin Graham and Warren Buffett.

The Core Valuation Philosophies:

While countless niche techniques exist, most valuations fall into three broad approaches: 

• Income-Based (Discounted Cash Flow, DCF): Projects future free cash flows and discounts them at the company’s cost of capital to find intrinsic value. Gold standard for intrinsic valuation, but highly sensitive to assumptions

• Market-Based (Comparables): Uses valuation multiples (P/E, EV/EBITDA, EV/Sales) from similar companies or M&A deals to infer a company’s value. Anchors valuation to what the market is paying for peers.

• Asset-Based: 

  • Tallies up tangible and intangible assets, less liabilities.

  • Includes book value, liquidation value, and replacement cost.

  • More relevant for asset-heavy industries (real estate, manufacturing) or distressed companies.

  • Less useful for modern firms driven by intangibles like brand, data, or network effects. For example, tech giants with modest tangible assets may carry trillion-dollar valuations because of the immense revenue potential tied to software platforms and digital ecosystems.

Discounted Cash Flow (DCF) in Practice

The underlying principle is the time value of money: a dollar today is worth more than a dollar tomorrow. Therefore, to find a company's value today, we must project all its future cash flows and "discount" them back to their present value.

Let's break down the process into four key steps:

1. Project future free cash flows for 5–10 years.

2. Estimate a terminal value (e.g., perpetual growth or exit multiple).

3. Discount using the Weighted Average Cost of Capital (WACC).

4. Sum present values for total enterprise value, then adjust for debt and cash to get equity value.

DCF forces analysts to articulate their assumptions about growth, profitability, and risk.

Relative Valuation: The Market Approach 

Comparable company analysis (“comps”) determines a company’s value by benchmarking against peers.

Process:

• Identify a peer group of companies with similar size, industry, and growth.

• Calculate valuation multiples for the group.

• Apply averages/medians to the target firm’s financials.

Common multiples:

• P/E (Price-to-Earnings)

• EV/EBITDA (Enterprise Value-to-EBITDA)

• P/S (Price-to-Sales)

This approach reflects “what the market is paying” and is especially useful as a sanity check on DCF results. A powerful extension of relative valuation is to compare a company not just to its peers, but also to itself over time. This involves analyzing a company's current multiples against its own historical averages (e.g., its 5-year or 10-year average P/E ratio). This historical context helps answer a crucial question: "Is the company cheap or expensive relative to its own past?"

A Real-World Example: Valuing Microsoft — $MSFT ( ▼ 1.23% )  

Disclaimer: Simplified example for educational purposes, based on late 2024/early 2025 data. Not investment advice.

Approach 1: Simplified DCF Valuation

Key Assumptions:

• Trailing Free Cash Flow to Firm (FCFF): ~$70B

• Growth: 12% in Year 1, tapering to 8% by Year 5

• Terminal Growth: 2.5%, in line with long-term global economic growth.

• WACC: For a mature, stable tech giant like Microsoft, a WACC of 8.5% is a reasonable assumption.

• Net cash ~$80 billion 

• Shares Outstanding: ~7.45 billion.

The Calculation:

1. Project FCF for 5 years:

   1. Year 1: 70B×1.12=$78.40B

   2. Year 2: 78.40B×1.11=$86.02B

   3. Year 3: 86.02B×1.10=$94.62B

   4. Year 4: 94.62B×1.09=$103.14B

   5. Year 5: 103.14B×1.08=$111.39B

2. Calculate Terminal Value (at the end of Year 5):

   1. First, we need the FCF for Year 6: $111.39B×(1+0.025)=$114.17B.

   2. Terminal Value = $114.17B/(0.085 - 0.025) = $114.17B/0.06 = $1,902.83B 

3. Discount all cash flows to Present Value (PV):

   1. PV of Year 1 FCF: $78.40B/(1.085)^1=$72.26B

   2. PV of Year 2 FCF: $86.02B/(1.085)^2=$73.08B

   3. PV of Year 3 FCF: $94.62B/(1.085)^3=$74.07B

   4. PV of Year 4 FCF: $103.14B/(1.085)^4=$74.39B

   5. PV of Year 5 FCF: $111.39B/(1.085)^5=$74.12B

   6. PV of Terminal Value: $1,902.83B/(1.085)^5=$1,266.02B

4. Calculate Enterprise and Equity Value:

   1. Enterprise Value (EV) = Sum of all PVs = $72.26+$73.08+$74.07+$74.39+$74.12+$1,266.02=$1,633.94B

   2. Equity Value = EV - Net Debt = $1,633.94B−(−$80B)=$1,713.94B

5. Calculate Implied Share Price:

   1. Implied Price per Share = $1,713.94B/7.45B shares≈$230

This gives us a single intrinsic value estimate. But we should never rely on one number.

Approach 2: Relative Valuation of Microsoft

Now, let's value Microsoft by comparing it to its peers.

Key Assumptions:

• Peer Group: Alphabet (GOOGL), Apple (AAPL), Amazon (AMZN), Oracle (ORCL).

• Relevant Multiples: We'll use two common ones: Price-to-Earnings (P/E) and Enterprise Value-to-EBITDA (EV/EBITDA).

• Peer Group Average Multiples (Illustrative):

  • Let's assume the peer group trades at an average P/E ratio of 28x.

  • Let's assume the peer group trades at an average EV/EBITDA multiple of 20x.

• Microsoft's Metrics:

  • Trailing Twelve-Month (TTM) EPS: $11.50

  • TTM EBITDA: $125B

The Calculation:

1. P/E Multiple Valuation:

   1. Implied Price = Microsoft EPS × Peer P/E Multiple

   2. Implied Price = $11.50×28=$322

2. EV/EBITDA Multiple Valuation:

   1. Implied EV = Microsoft EBITDA × Peer EV/EBITDA Multiple

   2. Implied EV = $125B×20=$2,500B

   3. Implied Equity Value = EV - Net Debt = $2,500B−(−$80B)=$2,580B

   4. Implied Price = $2,580B/7.45B shares=$346

putting all together:

This range highlights the uncertainty and the importance of understanding the assumptions driving each model. Charlie Munger once said that to solve a complex problem, invert, always invert. Turn a situation or problem upside down. Instead of guessing what a company might be worth, we let the market speak. We don’t start with our assumptions. Instead, we analyze the assumptions already baked into the stock price.  Then, we ask ourselves: Do these expectations make sense? If they seem too pessimistic, that’s where the opportunity lies.

Embracing the Uncertainty

Company valuation is not a search for a single, magical number. It is a framework for disciplined thinking. It forces you to articulate your assumptions about the future: How fast will it grow? How profitable will it be? How risky is the journey?

The final output should always be a range of values. Run scenarios: a base case, a bull case, and a bear case. Stress-test your assumptions. Understand what drives the value the most (is it the terminal growth rate? the WACC?).

In the end, the greatest value of performing a valuation is not the price target itself, but the deep understanding of the business you gain in the process. You learn its drivers, its risks, and its potential. This knowledge is your true compass, allowing you to navigate market volatility with confidence, make decisions based on logic rather than emotion, and ultimately, allocate your capital more wisely.

Stay disciplined!!!