The 3 Company Valuation Methods Explained
Summary of the video “How to Value a Company | Best Valuation Methods” by Kenji Explains.
Companies are valued using three main approaches: multiples-based (comparing to similar companies), discounted cash flow or DCF (projecting future cash flows), and cost approach (replacement cost). Each has strengths and weaknesses, so professionals use a 'football field' chart combining all three to derive a valuation range rather than a single number.
Why Value a Company
Business acquisition or sale
Companies are valued when considering buying or selling a business, department, or determining fair price in a transaction.
Investment decision-making
Individual investors value companies to determine if a stock is overpriced, underpriced, or fairly valued before buying shares.
Universal application across assets
The same three valuation methods apply beyond companies to real estate, software, departments, and other assets.
Method 1: Multiples-Based (Market) Approach
What is a multiple
A multiple is a ratio comparing one financial metric to another, such as price-to-earnings (P/E), enterprise value to sales, or enterprise value to EBITDA. It compares your company's worth relative to similar companies in the market.
Common multiples in finance
Key multiples include P/E ratio (price per share divided by earnings per share), enterprise value over sales, and EV/EBITDA (earnings before interest, tax, depreciation, and amortization).
Steps to apply multiples approach
Find comparable companies in the same industry, geography, and size; gather their price per share and earnings per share; calculate each company's P/E ratio; take the average (or median) P/E; multiply your target company's earnings by this average multiple to get the valuation.
P/E ratio example calculation
If five comparable companies have an average P/E ratio of 7.9, and your target company has earnings of 3 dollars, the valuation is 3 × 7.9 = 23.55 per share.
Limitations of multiples approach
P/E ratios don't work for unprofitable companies; average ratios can be skewed by outliers, making median preferable; finding truly comparable companies is difficult, especially for large or unique businesses.
Method 2: Discounted Cash Flow (DCF)
Intrinsic valuation concept
DCF focuses on a company's internal operations and cash flows rather than external market comparisons. It values a company based on projections of how much money it will generate in the future.
Time value of money principle
A dollar today is worth more than a dollar in the future due to inflation and opportunity cost. Therefore, future cash flows must be discounted back to present value using a discount rate.
DCF calculation example
Project stable cash flows (e.g., 10 million per year for 5 years). Discount each year's cash flow using the formula: Cash Flow ÷ (1 + discount rate)^year. Sum all discounted cash flows to get present value. With a 5% discount rate, year 1 is 10M ÷ 1.05, year 2 is 11M ÷ 1.05², and so on.
Terminal value necessity
After the projection period (e.g., 5 years), the company continues operating. Terminal value estimates the business value beyond the forecast period using either perpetual growth method or exit multiple method.
Discount rate and WACC
The discount rate reflects the company's cost of capital and risk. It is calculated using WACC (weighted average cost of capital), which accounts for both debt and equity financing costs.
Multiple scenario analysis
Professional DCF valuations typically include three scenarios: base case (expected performance), best case (optimistic with expansion), and worst case (pessimistic with setbacks). Each scenario produces a different valuation.
Method 3: Cost (Replacement Cost) Approach
Replacement cost principle
A company's value equals the cost to replace it with an equivalent new one. If your factory burned down, the replacement cost is what you'd pay to rebuild it.
Cost approach formula
Valuation = Replacement Cost (construction, architect fees, etc.) minus Depreciation (wear and tear reducing value) plus Land Value. This approach works best for tangible assets like manufacturing plants, houses, or cell towers.
Best suited for tangible assets
The cost approach works well for physical, touchable assets where replacement costs are clear. It is less effective for intangible assets like software or algorithms, where replication costs are unclear or impossible to determine.
Challenges with cost approach
Historical construction costs may not reflect current market prices; regulatory changes can make replacement impossible (e.g., zoning restrictions preventing rebuilding); costs are difficult to account for precisely.
Pros and Cons Comparison
Multiples approach strengths and weaknesses
Strengths: intuitive, easy to understand, relatively quick to execute. Weaknesses: difficult to find truly comparable companies, especially for large or unique businesses; market conditions heavily influence results.
DCF strengths and weaknesses
Strengths: independent of market conditions, focuses on intrinsic company value. Weaknesses: time-consuming and complex; heavily dependent on assumptions about future growth, making valuations prone to optimism or pessimism bias.
Cost approach strengths and weaknesses
Strengths: straightforward and easy to understand. Weaknesses: costs are difficult to account for accurately; regulatory changes can make replacement impossible; less applicable to intangible assets.
The Football Field Valuation
Why combine all three methods
Since no single valuation method is perfect, professionals bundle all three approaches into a single visualization called a football field chart to derive a valuation range rather than a single number.
Football field chart structure
The chart displays valuation ranges from each of the three methods (multiples, DCF, cost) as horizontal bars. It also includes the company's 52-week high and low stock price range for market context.
Valuation as art and science
Valuation is regarded as both an art and a science because it requires technical analysis combined with judgment. Analysts use the football field to understand the range of possible values rather than seeking one precise number.
Notable quotes
A dollar today is worth more than a dollar in the future. — Kenji
Valuation is mainly regarded as both an art and a science. — Kenji
None of the three methods are actually perfect. — Kenji