Quantitative Valuation

Quantitative Valuation

Core Concepts

Discounted Cash Flow (DCF)

The DCF model values a company as the present value of its future free cash flows plus a terminal value:

V = Σ FCF_t / (1 + WACC)^t + TV / (1 + WACC)^n

where FCF_t is the free cash flow in year t, WACC is the weighted average cost of capital, and TV is the terminal value at the end of the explicit forecast period.

Terminal Value — Gordon Growth Model

Estimates the value of all cash flows beyond the explicit forecast period assuming perpetual growth:

TV = FCF_n × (1 + g) / (WACC - g)

where g is the long-term sustainable growth rate (typically near nominal GDP growth, 2-4%).

Terminal Value — Exit Multiple Method

Estimates terminal value by applying a market multiple to the final-year financial metric:

TV = EBITDA_n × EV/EBITDA multiple

The exit multiple is typically based on current peer trading multiples or long-run sector averages.

Weighted Average Cost of Capital (WACC)

Blends the cost of equity and after-tax cost of debt weighted by their market-value proportions:

WACC = w_e × r_e + w_d × r_d × (1 - τ)

where w_e and w_d are equity and debt weights, r_e and r_d are their respective costs, and τ is the marginal tax rate.

Cost of Equity — CAPM

The Capital Asset Pricing Model estimates the required return on equity:

r_e = R_f + β × (R_m - R_f)

where R_f is the risk-free rate, β is the stock's sensitivity to market returns, and (R_m - R_f) is the equity risk premium.

Dividend Discount Model (DDM)

Values a stock as the present value of its future dividends. The Gordon Growth (single-stage) form:

P = D_1 / (r - g)

where D_1 is the next-period dividend, r is the required return, and g is the constant dividend growth rate.

Multi-Stage DDM

Accommodates companies transitioning through growth phases:

• Stage 1 (High growth): Dividends grow at g_1 for n years
• Stage 2 (Transition): Growth declines linearly from g_1 to g_3
• Stage 3 (Stable): Dividends grow at g_3 in perpetuity (valued via Gordon Growth)

Residual Income Model

Values a company as its book value plus the present value of economic profits:

V = BV_0 + Σ (ROE - r) × BV_{t-1} / (1 + r)^t

This model is useful when free cash flows are negative but the company earns above its cost of equity.

Comparable Multiples

Relative valuation uses pricing ratios from a peer group to infer value:

• P/E (Price-to-Earnings): most common for profitable companies
• EV/EBITDA (Enterprise Value to EBITDA): capital-structure neutral
• P/S (Price-to-Sales): useful for unprofitable or early-stage companies
• P/B (Price-to-Book): useful for asset-heavy businesses (banks, REITs)

Use the median of the peer group to reduce outlier effects. Adjust for differences in growth, margins, and risk.

Relative Valuation

Compare a stock's current multiple to:

• Its own historical average (time-series comparison)
• Sector or industry median (cross-sectional comparison)

A stock trading at a discount to both may be undervalued, or there may be fundamental deterioration.

Sum-of-the-Parts (SOTP)

Value each business segment separately using the most appropriate method (DCF, multiples, or asset-based), then sum. Subtract net debt and add non-operating assets to arrive at equity value.

Sensitivity Analysis

Vary key assumptions (WACC and terminal growth rate are the most impactful) in a two-way data table to understand the range of possible valuations. This exposes which assumptions drive the result.

Key Formulas

Worked Examples