Stock Valuation: 3 Methods You Need to Know (with Examples)

I've spent a decade valuing businesses—from mom-and-pop shops to tech unicorns. When investors ask 'What are the three methods of stock valuation?' they usually want a neat list. Here it is: discounted cash flow (DCF), relative valuation (comparables), and asset-based valuation. But knowing the names isn't the same as knowing when to use them. That's what this guide is about.

1. The Income Approach: Discounted Cash Flow (DCF)

What Is DCF?

DCF says a company's value equals the sum of its future free cash flows, discounted back to today at an appropriate rate. The math is simple: value = Σ FCF_t / (1+WACC)^t + terminal value. The challenge is the inputs. As Aswath Damodaran puts it in 'Investment Valuation', you can make a DCF spit out almost any number you want by tweaking assumptions.

Step-by-Step DCF Calculation

Here's a practical walkthrough for Widget Inc. (fictional). Free cash flow for the next five years and terminal value are estimated as follows:

Sum of PVs ≈ $17,106,550. With 1M shares, that's ~$17.11 per share. But if I change terminal growth from 2% to 4%, the value jumps to $21.23—a 24% swing from one assumption. That fragility is why I always run a sensitivity table before trusting any DCF output.

The DCF Reality Check

Here's where experience kicks in. Most DCF models I've seen in the wild have more assumptions than a politician's promise. The WACC alone involves guessing equity risk premium, beta, cost of debt, etc. For a mature company like a utility, DCF is solid. For a volatile SaaS startup, it's a fantasy. I once built a DCF for a tech company and the valuation ranged from $12 to $85 per share depending on the terminal growth assumption. Totally useless.

2. The Market Approach: Relative Valuation

The Concept

Relative valuation compares your target to similar companies using multiples like P/E, EV/EBITDA, or P/B. If the average P/E of comparable companies is 15, and your target trades at 12, it might be undervalued. Simple, right? Not exactly. The CFA Institute's curriculum emphasizes that the comparables must be truly homogeneous—same industry, similar risk, growth, and margins. In practice, that's rare.

Common Multiples

Choosing Comparables

You need a set of truly comparable companies. Industry, size, growth, margins—all should align. Picking Tesla as a comp for Ford is a classic mistake. I've seen analysts stretch comparables so far that they'd make a rubber band jealous. For example, when valuing a small regional bank, some folks include money center banks. That's nonsense.

The GroupThink Trap

When the whole market is expensive, relative valuation will tell you your company is cheap, based on inflated peers. In the late 1990s, every dot-com looked 'reasonable' compared to others, until they weren't. So use relative multiples as a screen, not a verdict. I usually compare the target's multiple to its own historical range too, which gives a better sense of where it sits.

3. The Asset-Based Approach: Book Value & Liquidation

The Basics

Asset-based valuation values a company based on its net assets—total assets minus liabilities. You adjust book values to fair market value, then compare to the stock price. This method works best for asset-heavy firms like real estate, mining, or holding companies. For example, a shipping company with undervalued vessels can be a goldmine if you can unlock that value.

Book Value Is Not Market Value

Book value comes from accounting records, not market prices. A factory built in the 1980s may be undervalued on the books if land prices have surged. On the flip side, intangibles like brand reputation aren't on the balance sheet. So asset-based can miss the whole story. I remember analyzing a beverage company where the brand was worth half the market cap, but the balance sheet showed no trace of it.

When to Use It

I use this approach when looking for liquidation plays or when a company's assets have hidden value. A classic example is mining companies: the book value of reserves can be far below their market value if commodity prices have risen. But for tech or service companies, this method is almost useless.

Which Method Should I Actually Use?

My personal rule: match the method to the company's lifecycle.

• Mature, predictable cash flows: DCF.
• Profitable, with good peers: Relative valuation.
• Asset-rich, underperforming: Asset-based.
• Startups or high-growth: None of the typical ones work well—look at revenue multiples or use DCF with a lot of salt.

But here's my controversial take: for most individual investors, relative valuation is the most practical. DCF sounds fancy but produces a precision that's illusion. I've seen people calculate DCF to the cent and completely miss that their revenue growth assumption was off by 50%. Relative valuation forces you to confront the market's mood—which, love it or hate it, drives price.

A Real-World Example: Valuing Widget Inc.

Assume Widget Inc. has:

• Free cash flow: stable at $10 million next year, growing 3% forever.
• Beta: 1.2, risk-free rate 4%, market return 9% → WACC ~10%.
• EPS: $2.00, book value per share: $20.

DCF: FCF = $10M, terminal growth 3%, WACC 10%. Value = $10M / (10%-3%) = $142.86M. With 10M shares, that's $14.29 per share.

Relative: Industry average P/E = 15. With EPS $2, fair value = $30 per share.

Asset-based: Book value $20 per share, but assets are old. Adjust to replacement cost: $25 per share.

Which is right? They're all different—$14.29, $30, $25. That's not a math error; it's a sign of different assumptions. As an investor, I'd dig deeper into why book assets are undervalued and whether the cash flow is truly stable. In practice, I often use a weighted blend, but I never treat the output as a precise number.

Frequently Asked Questions