Valuation Models: All The Basics You Need To Know

Valuation models are used to answer this simple yet complex question:

“What is a company worth?”

Putting a price tag on a business or asset isn’t guesswork. It’s a calculated process built on the foundations of valuation models. Whether you’re an investor trying to decide when to buy a stock, an analyst modelling a company’s financial future or an aspiring investor or analyst, understanding how to value a business is essential.

This article (the first in an eight-part series) introduces the most widely used valuation models and explains when, why, and how they’re used.

What Is Valuation?

Valuation involves estimating the economic value of an asset or an entire business. It’s how investors and analysts figure out what an investment is worth paying for today based on its current price and future potential. 

Valuation is used in finance for:

• Making Investment Decisions: Is this stock overvalued, fairly valued or undervalued?
• Mergers & Acquisitions: How much do we pay for another company?
• Raising Capital: How much is our business worth to investors?

To assess a company’s value and get answers to the above questions, investors and analysts use models from one (or both) of the two main valuation categories.

• Intrinsic (Absolute) Valuation: A company’s value is calculated based on its fundamentals, such as free cash flows, earnings and dividends.
• Relative Valuation: A company’s value is calculated by comparing it against similar companies.

A complete valuation model incorporates the two: intrinsic and relative.

Types of Valuation Models

Valuation models are the tools used to calculate the value of an investment. Some examples, by category, include the following.

Discounted Cash Flow (DCF) Analysis – Intrinsic Valuation Model

The DCF is the most used (and referred to) valuation model. It estimates a company’s intrinsic value by forecasting future free cash flows and discounting them to their present value. Discounting accounts for the time value of money at a rate that adequately reflects the risk associated with the investment, like the company’s weighted average cost of capital (or WACC).

For an in-depth breakdown, click here.

Dividend Discount Model (DDM) – Intrinsic Valuation Model

The DDM is similar to the DCF but replaces free cash flows with dividends and WACC with COE (cost of equity). It forecasts future dividends and discounts them to their present value using the company’s cost of equity. 

Because dividends are equity-related items, the cost of equity (the minimum return investors expect for investing in the company) is used in place of WACC.

For an in-depth breakdown, click here.

Comparable Companies Analysis (CCA) – Relative Valuation Model

CCA, or trading comps, is the most well-known relative valuation model. It calculates a company’s value by using the market multiples of its peers and assigning them to the company’s financials.

For an in-depth breakdown, click here.

Precedent Transaction Analysis – Relative Valuation Model

Precedent Transaction Analysis, or M&A comps, values companies based on the prices paid for similar companies in past mergers and acquisitions. It is similar to CCA but supplements other models when buying entire companies.

For an in-depth breakdown, click here.

Choosing The Right Valuation Model

With so many valuation models available, how do you choose the right one?

The answer depends on the company you’re assessing. So, here are some things to consider.

In practice, investors and analysts rarely rely on a single valuation model. Instead, they use multiple approaches to:

• Cross-validate results (e.g., DCF plus CCA)
• Establish a valuation range (e.g., low-end CCA vs high-end DCF)
• Stress-test assumptions (e.g., sensitivity analysis in DCF)

This triangulation increases confidence in valuation outcomes and helps account for different perspectives, including market sentiment, internal performance and fundamental value.

Key Inputs & Assumptions

Valuation models are only as good as the assumptions behind them. 

For intrinsic valuation models, key inputs and assumptions include:

• Growth Rates – How fast free cash flows or dividends will grow
• Discount Rates – What the projections will be discounted by
• Profit Margins – Used to calculate items without forecasting entire financial statements
• Terminal Value Assumptions – Often 60–70% of the total value, so they’re essential to get ‘right’

For relative valuation models, key inputs and assumptions include:

• Company Choice – Don’t choose a tech company when you’re valuing a grocery chain
• Company Data – Ensure the financials used (1) are calculated using the same method and (2) make sense for the company being valued.

Limitations of Valuation & Valuation Models

While valuation models are powerful tools, they are far from perfect. 

It’s easy to believe that these models offer precise answers. But, in reality, they only provide estimates of value based on assumptions.

Here are some things to keep in mind when using any valuation model.

Garbage In, Garbage Out (GIGO)

All models rely on input data and assumptions. If they are overly optimistic or pessimistic, the outcome will be misleading.

For example:

• Overestimating growth rates in a DCF model can make an average company appear to be a high-growth superstar.
• Using inappropriate peer companies in a CCA can skew results, especially if those peers are over- or undervalued.

The accuracy of a valuation model is directly tied to the quality and realism of the assumptions that go into it.

Ignores Qualitative Factors

Valuation models are quantitative by nature. They rely on numbers and formulas but often ignore qualitative drivers of value, such as:

• Innovation pipelines and competitive advantages
• Brand strength and management quality
• Company culture

These factors can significantly affect a company’s long-term value, but they’re difficult (if not impossible) to capture in standard models. As a result, many valuation models miss the complete picture.

Difficulty in Forecasting the Future

Most valuation models require future projections – revenue, margins, investment needs and cash flows. But forecasting is inherently challenging, especially in:

• Rapidly evolving industries (e.g., tech, biotech)
• Economic downturns or market disruptions
• Early-stage companies with no financial history

Even experienced analysts struggle to make accurate long-term forecasts. Therefore, models are best viewed as educated guesses, not guarantees.

Section Summary

Valuation models are not crystal balls. They are structured tools designed to help make informed decisions, but must be used with caution, context, and common sense.

Knowing the limitations of valuation models makes you a better analyst or investor. You’re more realistic about what your numbers can (and can’t) tell you.

Rounding It All Up!

Valuation is more than crunching numbers. It’s the art and science of determining what a company is truly worth. 

Whether it’s a DCF model to project cash flows, comparing similar companies with CCA, or valuing dividends, each approach offers unique insights. That’s why the best investors and analysts don’t rely on just one. They use a combination of models to cross-check outcomes and deepen their understanding of a potential investment.

By understanding the valuation process, you’re not just learning to calculate numbers; you’re learning to see value where others might not.