Practical stock researchModule 3, lesson 11 of 23
Choosing a valuation method
Matching valuation methods to businesses: DCF for steady cash generators, P/B for lenders, normalised earnings for cyclicals, and cross-checking results.
In this lesson
- Match a valuation method to a company's business model and stage.
- Value a lender using price-to-book linked to return on equity.
- Use normalised earnings to value a cyclical business.
- Cross-check one method against another and explain differences.
Builds on
- Comparable-company valuationMultiples-based valuation is one of the methods compared here.
- Discounted cash flow valuationDCF is the main intrinsic valuation method compared here.
- Why sectors are valued differentlyThat lesson explains why different sectors are valued differently.
On this page
In simple terms
Valuation methods are tools, and each suits some jobs better than others. A method that works well for a steady consumer goods company can give nonsense for a bank or a steel maker. Choosing the method starts with understanding how the business creates value, from the earlier research steps.
Matching methods to businesses
| Kind of business | Methods that usually fit | Why |
|---|---|---|
| Steady cash generator (consumer goods, software, utilities) | DCF, free cash flow yield, P/E | Cash flows are fairly predictable, as the DCF lesson explains |
| Bank or lender | Price-to-book linked to return on equity | Assets and liabilities are financial; book value and ROE drive value, as the analysing banks lesson explains |
| Cyclical (metals, cement, autos, chemicals) | Normalised earnings, EV/EBITDA across a cycle, replacement cost | Peak and trough profits mislead |
| Early-stage or loss-making | EV/sales with a path to margins, reverse DCF | Today's earnings say little about mature earnings |
| Group or holding company | Sum of the parts, often with a discount | Different businesses deserve different values |
| Property developer or asset owner | Net asset value | Value lies largely in land and buildings, as the real estate lesson explains |
Lenders: book value and returns
For a bank, what matters is how much it earns on its shareholders' equity compared with what shareholders require. A simple link is:
Justified P/B = (ROE − g) ÷ (r − g), where ROE is the sustainable return on equity, r the cost of equity and g long-term growth.
| Sustainable ROE | 15% |
|---|---|
| Cost of equity | 12% |
| Long-term growth | 8% |
| Justified P/B: (0.15 − 0.08) ÷ (0.12 − 0.08) | 1.75 |
| If ROE were 10%: (0.10 − 0.08) ÷ (0.12 − 0.08) | 0.5 |
A lender earning below its cost of equity deserves a discount to book value, however fast it grows. Book value itself must be trusted, which depends on bad loans being recognised properly.
Cyclicals: normalised earnings
At the top of a cycle, a cyclical company's profits are high and its P/E looks low; at the bottom, profits vanish and the P/E looks absurd, as the cyclical businesses lesson explains. Valuing on normalised earnings, an average across a full cycle, gives a steadier picture.
Worked example: A made-up steel maker
Profits over six years, in ₹ crore: 900, 600, 100, −50, 400, 800.
| Average profit across the cycle | about ₹458 crore |
|---|---|
| Value at 12 times peak profit of ₹900 crore | ₹10,800 crore |
| Value at 12 times normalised profit | about ₹5,500 crore |
Using the peak would roughly double the value.
Early-stage and loss-making companies
When a company has no profits yet, its value depends on whether and when it reaches mature margins. EV/sales multiples hide that question. A better approach is to sketch a path to mature revenue and margins, or to use a reverse DCF to see what the current price assumes, then judge whether those assumptions are plausible.
Groups: sum of the parts
For a company with several distinct businesses, value each part with a method that suits it, add them up, and subtract net debt at the holding level. Groups often trade at a discount to the sum, because of holding company costs, tax on eventual sales, and doubts about how cash will reach minority shareholders, as the group structures lesson explains.
Cross-checking
Use at least two methods. If a DCF gives ₹800 a share and peer multiples suggest ₹450, find out why:
- Does the DCF assume growth or margins far above peers?
- Are peers all expensive, or all cheap?
- Is the company genuinely different?
Agreement between methods does not prove you are right, because both can rest on the same optimistic assumption. But large unexplained gaps show where your thinking needs work, as the comparables lesson discusses.
Why it matters
The wrong method can make an expensive company look cheap, or a sound one look absurd. Choosing a method that fits how the business creates value, and checking it against another, produces valuations you can defend and challenge.
Limitations
Every method rests on assumptions about the future. Simple formulas such as justified P/B assume steady conditions that rarely hold. Normalised earnings depend on judging what a normal cycle looks like. Methods structure judgement; they do not replace it.
Common mistakes
- Using P/E for banks or cyclicals without adjustment.
- Valuing cyclicals on peak earnings.
- Using EV/sales without a path to profit.
- Relying on one method without a cross-check.
Try it yourself
- For a company you are researching, decide which kind of business it is and choose two suitable methods.
- Value it with both, writing down every assumption.
- Explain any difference of more than 20% between the two values.
- Note which assumption, if wrong, would change the value most.
Key takeaways
- No single method suits every company. Choose the method that reflects how the business creates value.
- DCF and free cash flow yields suit steady cash generators. Price-to-book linked to return on equity suits banks and lenders.
- Cyclical companies are best valued on normalised earnings across a cycle, not on peak or trough profits.
- Loss-making or early-stage companies need a path to future margins, tested with a reverse DCF. Groups and holding companies often need a sum-of-the-parts approach.
- Use at least two methods and explain why they differ. Agreement does not prove you are right, but large unexplained gaps show where your assumptions need work.
Check your understanding
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Terms used in this lesson
- Discounted cash flow
- A valuation method that estimates a business's worth as the present value of the free cash flow it will generate.
- Price-to-book ratio
- The share price divided by book value per share, or market capitalisation divided by shareholders' equity.
- Normalised earnings
- An estimate of what a cyclical company earns in an average year across a full cycle, used instead of peak or trough profit.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.