Equity Valuation Secrets: 3 Powerful Methods Every Investor Must Know

---

📖 The Story Behind Valuing a Company

Years later, Rajesh reflected on that painful mistake. It wasn’t that the company was bad — it was that he had no framework to judge whether the stock price made sense. If he had known how analysts use tools like the Dividend Discount Model (DDM), Discounted Cash Flow (DCF), or Relative Valuation (Multiples), he could have avoided being swept away by market hype.

That’s the essence of equity valuation. Behind every stock price is a story — of dividends, cash flows, growth, and market perception. And as investors, our job is to separate the noise from reality.

---

📊 Understanding Equity Valuation: DDM vs DCF vs Relative Models

Valuing a company’s stock is at the heart of investing. But with multiple valuation models available, which one should you rely on? The answer often depends on the type of company and the purpose of your analysis. Let’s break down the three most widely used approaches: the Dividend Discount Model (DDM), the Discounted Cash Flow Model (DCF), and Relative Valuation Models.

---

🔹 1. Dividend Discount Model (DDM)

The Dividend Discount Model is one of the oldest valuation methods. It assumes that a stock’s value is simply the present value of all future dividends it will pay.

• Formula (Gordon Growth Model): P0=D1r−gP_0 = \frac{D_1}{r – g}P0​=r−gD1​​ where D1D_1D1​ is the expected dividend, rrr is the cost of equity, and ggg is the dividend growth rate.
• When to Use:
  • Mature companies with consistent dividend payouts (banks, utilities, FMCG).
• Strength: Simple, dividend-focused.
• Weakness: Doesn’t work for companies that don’t pay dividends or have erratic payout policies.

---

🔹 2. Discounted Cash Flow Model (DCF)

The DCF model looks beyond dividends. It values a company based on the free cash flows it can generate in the future, discounted back at the appropriate cost of capital.

• Steps:
  1. Forecast revenues, margins, capex, and working capital.
  2. Estimate free cash flows (FCF).
  3. Discount FCF at the cost of capital.
  4. Add terminal value to capture long-term growth.
• When to Use:
  • Growth firms, startups, or companies reinvesting heavily rather than paying dividends.
• Strength: Comprehensive, captures firm fundamentals.
• Weakness: Highly sensitive to assumptions on growth, discount rate, and terminal value.

---

🔹 3. Relative Valuation (Multiples Approach)

Sometimes, the best way to value a company is to compare it with its peers. This is where relative valuation comes in.

• Common Multiples:
  • Price-to-Earnings (P/E)
  • Enterprise Value / EBITDA
  • Price-to-Book (P/B)
  • Price-to-Sales (P/S)
• When to Use:
  • Benchmarking against competitors.
  • Quick checks against market sentiment.
• Strength: Market-driven, easy to apply.
• Weakness: Peer group choice can distort results; ignores unique fundamentals.

---

🔹 Putting It All Together

No single model is perfect. Analysts typically use a combination of methods:

• DDM for stable dividend-paying firms,
• DCF as the core valuation for most businesses,
• Relative Valuation as a cross-check against market pricing.

By triangulating between these models, investors gain a more balanced and reliable view of a company’s true worth.

---

💡 Final Thought

Equity valuation is as much an art as it is a science. Models provide the framework, but judgment, market context, and sector knowledge make the difference. The key is not to rely on just one method—but to use them together for better decision-making.

Let’s walk through each model (DDM, DCF, Relative Valuation) with a simple example so you can see the actual calculation step by step.

---

📊 Example: Valuing XYZ Ltd.

Suppose we are trying to value XYZ Ltd., a listed company. Here are some assumptions:

• Current dividend per share: ₹5
• Expected dividend growth rate (g): 6% per year
• Cost of equity (r): 10%
• Projected Free Cash Flow to Firm (FCFF): grows at 8% for the next 5 years, then stabilizes at 4%
• Peer group average P/E multiple: 18x
• XYZ Ltd.’s expected EPS next year: ₹100

---

1️⃣ Dividend Discount Model (DDM)

We use the Gordon Growth Model (assuming dividends grow forever at constant rate g): P0=D1r−gP_0 = \frac{D_1}{r – g}P0​=r−gD1​​

• Next year’s dividend = D1=5×(1+0.06)=₹5.30D_1 = 5 \times (1+0.06) = ₹5.30D1​=5×(1+0.06)=₹5.30
• r=10%=0.10r = 10\% = 0.10r=10%=0.10
• g=6%=0.06g = 6\% = 0.06g=6%=0.06

P0=5.300.10−0.06=5.300.04=₹132.5P_0 = \frac{5.30}{0.10 – 0.06} = \frac{5.30}{0.04} = ₹132.5P0​=0.10−0.065.30​=0.045.30​=₹132.5

👉 According to DDM, the stock is worth ₹132.5 per share.

---

2️⃣ Discounted Cash Flow (DCF) Model

Let’s assume projected Free Cash Flow to Firm (FCFF):

• Year 1: ₹200 Cr
• Year 2: ₹216 Cr (grows 8%)
• Year 3: ₹233 Cr
• Year 4: ₹252 Cr
• Year 5: ₹272 Cr

After Year 5, growth slows to 4% (terminal growth rate).
Discount rate (WACC) = 10%.

Step 1: Discount projected cash flows

PV=FCFt(1+r)tPV = \frac{FCF_t}{(1+r)^t}PV=(1+r)tFCFt​​

• Year 1: 200/1.1=182200 / 1.1 = 182200/1.1=182
• Year 2: 216/(1.1)2=179216 / (1.1)^2 = 179216/(1.1)2=179
• Year 3: 233/(1.1)3=175233 / (1.1)^3 = 175233/(1.1)3=175
• Year 4: 252/(1.1)4=172252 / (1.1)^4 = 172252/(1.1)4=172
• Year 5: 272/(1.1)5=169272 / (1.1)^5 = 169272/(1.1)5=169

Sum (Years 1–5) = ₹877 Cr

Step 2: Terminal Value (TV) at Year 5

TV=FCF6r−g=272×1.040.10−0.04=282.90.06=₹4715CrTV = \frac{FCF_6}{r – g} = \frac{272 \times 1.04}{0.10 – 0.04} = \frac{282.9}{0.06} = ₹4715 CrTV=r−gFCF6​​=0.10−0.04272×1.04​=0.06282.9​=₹4715Cr

Discounted back: PVTV=4715(1.1)5=₹2928CrPV_{TV} = \frac{4715}{(1.1)^5} = ₹2928 CrPVTV​=(1.1)54715​=₹2928Cr

Step 3: Total Firm Value

EV=877+2928=₹3805CrEV = 877 + 2928 = ₹3805 CrEV=877+2928=₹3805Cr

👉 According to DCF, the firm’s value = ₹3805 Cr. Divide by number of shares outstanding (say 25 Cr shares): Value per share=380525=₹152Value \ per \ share = \frac{3805}{25} = ₹152Value per share=253805​=₹152

---

3️⃣ Relative Valuation (Multiples)

Given:

• Peer group average P/E = 18x
• XYZ Ltd.’s expected EPS = ₹100

Value per share=EPS×P/E=100×18=₹1800Value \ per \ share = EPS \times P/E = 100 \times 18 = ₹1800Value per share=EPS×P/E=100×18=₹1800

👉 According to relative valuation, the stock is worth ₹1800 per share.

---

✅ Comparison of Results

Method	Value per share
DDM	₹132.5
DCF	₹152
Relative (P/E)	₹1800

---

🔎 Interpretation

• DDM gives a low value, since dividends are relatively small compared to earnings.
• DCF provides a more balanced view, reflecting future cash flows.
• Relative valuation shows a much higher number — suggesting the market pays a premium for peers (maybe due to growth expectations, brand, or sector hype).

👉 In real-world practice, an analyst would triangulate between these models to arrive at a fair valuation range.

---

🔎 Triangulating Equity Valuation Methods

When analysts value a stock, they rarely rely on a single model. Each method captures a different perspective:

• DDM → Focuses only on dividends (income for shareholders).
• DCF → Captures the company’s true cash-generating ability.
• Relative Valuation → Reflects how the market is pricing peers.

By combining all three, analysts balance fundamentals, income, and market sentiment.

🧭 Step 1: Assess Reliability of Each Model

• DDM (₹132.5)
  • XYZ pays low dividends compared to earnings.
  • DDM undervalues companies that retain profits for growth.
  • Analyst conclusion → Low weight (not very reliable here).
• DCF (₹152)
  • Based on fundamentals: free cash flow, growth, terminal value.
  • Best reflection of intrinsic value if assumptions are reasonable.
  • Analyst conclusion → High weight (most reliable).
• Relative Valuation (₹1800)
  • Shows the market is paying very high multiples for peers.
  • Could be due to sector hype or investor optimism.
  • Analyst conclusion → Cross-check only (market-driven, but can be inflated).

---

🧭 Step 2: Assign Weights

Analysts often assign weights to each method based on relevance:

• DDM → 10% (since dividends aren’t the main driver)
• DCF → 60% (captures fundamentals best)
• Relative → 30% (reflects market perception)

---

🧭 Step 3: Weighted Average

Fair Value=(132.5×0.10)+(152×0.60)+(1800×0.30)Fair\ Value = (132.5 \times 0.10) + (152 \times 0.60) + (1800 \times 0.30)Fair Value=(132.5×0.10)+(152×0.60)+(1800×0.30) =13.25+91.2+540=₹644.5= 13.25 + 91.2 + 540 = ₹644.5=13.25+91.2+540=₹644.5

👉 Fair Value Estimate ≈ ₹650 per share

---

🎯 Analyst’s Final View

• Intrinsic value (DCF) suggests the business fundamentals justify ~₹150 per share.
• Market sentiment (Relative) pushes the number much higher (~₹1800).
• By triangulating, the analyst finds a middle ground (~₹650).

This tells us:

• Market may be overpricing peers (bubble risk).
• The stock might be undervalued if growth justifies higher multiples.
• Final recommendation → “Fair Value Range: ₹600–₹700 per share” (but watch sector sentiment).

---

🔎 Investment Thesis

• Strong Fundamentals (DCF Value ~₹152):
  XYZ Ltd. generates consistent free cash flows and has healthy growth prospects. However, intrinsic cash flow value alone suggests a modest per-share valuation.
• Low Dividend Yield (DDM Value ~₹132.5):
  Dividend payouts are relatively small compared to earnings, making DDM less relevant for this stock.
• High Market Multiples (Relative Value ~₹1800):
  Peer group trades at elevated valuations (avg. P/E ~18x), significantly above fundamental value. This reflects sector optimism and investor sentiment, not necessarily underlying cash flows.

---

🎯 Analyst Conclusion

Triangulating the three methods, we estimate a fair value of ~₹650 per share.

• At current levels (~₹620), the stock trades close to fair value.
• Upside is limited unless earnings growth accelerates to justify higher multiples.
• Downside risk exists if sector multiples de-rate closer to intrinsic fundamentals.

---

✅ Recommendation

• Rating: HOLD
• Fair Value Range: ₹600 – ₹700
• Catalysts: Faster revenue growth, margin expansion, or higher dividend payout.
• Risks: Market de-rating, lower cash flow generation, or over-dependence on sector hype.

---

🔎 Why Not a SELL Rating?

Although intrinsic value (DCF ~₹152) is far below the market multiples, analysts usually consider three factors before giving a SELL:

1. Current Price vs Fair Value Range

• Our triangulated fair value = ~₹650.
• If current price is ~₹620, the stock is within the fair value band (₹600–₹700).
• Analysts usually issue SELL only if price is well above fair value, say >20–30% overvaluation.

👉 Since the stock is trading fairly valued, SELL may be too harsh.

---

2. Market Sentiment and Relative Valuation

• Peers are trading at very high multiples (P/E ~18x).
• If XYZ trades significantly below peers, issuing SELL could ignore the market’s willingness to pay a premium for the sector.
• A HOLD signals: “It’s not cheap, but not overvalued relative to the market either.”

👉 SELL might not align with how the sector is priced.

---

3. Analyst Communication

• A HOLD rating often communicates: “No strong reason to buy, but also no urgency to sell.”
• SELL ratings are relatively rare because they imply clear overvaluation and strong downside risk.
• Since our fair value (~₹650) is close to market price (~₹620), HOLD is the neutral and professional stance.

---

🆚 What Would Justify a SELL?

XYZ Ltd. would deserve a SELL if:

• The stock was trading significantly above fair value (e.g., at ₹900 or ₹1,200 when fair value is ₹650).
• There was clear downside risk not priced in (weakening cash flows, regulatory threats, competitive losses).
• Sector multiples were normalizing, and relative valuation no longer supported high premiums.

✅ Revised View (if stricter fundamental lens is used)

If the analyst gives more weight to DCF (since intrinsic value is much lower at ₹152), the case for a SELL strengthens. But in practice, because investors benchmark against peers and the stock trades in line with the triangulated fair value, most equity research desks would keep it at HOLD.

---

✅ Key Takeaway:
Triangulation isn’t about averaging numbers blindly. It’s about understanding what each model captures, assigning importance, and arriving at a valuation range that balances fundamentals with market reality.

---

🌟 Closing Thoughts

Rajesh’s story could have ended differently. If back then he had paused, run the numbers, and asked “What is this stock truly worth?” he might have protected his savings and invested with confidence.

That’s the power of equity valuation. Whether through the Dividend Discount Model (DDM), the Discounted Cash Flow Model (DCF), or Relative Valuation, these tools give you a lens to see beyond market noise and hype.

The next time you face a stock tip or a tempting rally, remember: prices move fast, but value is steady. Just like Rajesh, you’ll have a choice — to follow the crowd blindly, or to use valuation models to make decisions grounded in clarity and conviction.

Your investments deserve more than guesswork. They deserve the discipline of valuation.

Read more blogs on Finance & Corporate Governance here. External reference Investopedia.