How to Value a Business: DCF, Multiples, and Dividend Discount Explained

While previous chapter was focused on screening - using metrics and filters to narrow and find companies worth closer looking. In this chapter we will focus on valuation and predictions, which, in other hand, answers a much harder question, what is this business actually worth? A stock looking cheap on a screener can still be expensive if future cash flows don't justify the price. Valuing a business requires going beyond ratios and understanding the underlying economics that drive long-term value.

Below are the core valuation frameworks investors use to estimate intrinsic value and assess whether a stock offers a meaningful margin of safety. I will not go deep into the mathematics behind these methods. Doing so would broaden the topic too much, and there is already a large body of books dedicated to this subject. The goal here is to explain the core idea behind each approach and why it matters.

These models are tools, not answers, and they are most useful when combined with long-term, business-focused thinking.

Discounted Cash Flow (DCF)

The Discounted Cash Flow model is one of the most famouse and commonly used valuation method. DCF values a business based on the cash it can generate over its lifetime. Instead of relying on current market sentiment, DCF forces you to think like an owner: how much cash will this company produce, and what is that cash worth today?

In practice, this means forecasting free cash flows, discounting them back using a required rate of return, and estimating a terminal value. DCF is highly sensitive to assumptions, which is why it should not be used to produce a single “correct” number. Its real value lies in showing what must go right for an investment to make sense.

DCF works best for businesses with stable operations and relatively predictable cash flows. For cyclical, early-stage, or structurally challenged companies, the model often creates an illusion of precision.

Discounted Cash Flow Advantages

• Focuses on cash generation, not accounting optics and tricks
• Forces long-term thinking and explicit assumptions
• Projections can be tweaked to provide different results for different scenarios

Discounted Cash Flow Disadvantages

• Major limitation is that analysis is using estimates, not actual figures
• Future cash flows rely on variety of factors, the status of economy, competition, market demand, which are hard to estimate
• Difficult to apply to cyclical, early-stage, or declining business

DCF should be viewed as a tool for stress-testing assumptions, not as a precise valuation formula.

Dividend Discount Model (DDM)

The Dividend Discount Model values a stock based on the present value of future dividend payments. It is most applicable to mature businesses with stable cash flows and consistent payout policies. (Check term "Dividend Aristocrats")

DDM is intentionally conservative. It ignores reinvestment optionality and works poorly for companies that favor buybacks or aggressive growth. However, for income-focused businesses, it provides a clear link between shareholder returns and intrinsic value.

This model is less about forecasting growth and more about assessing durability and capital discipline.

Dividend Discount Model Advantages

• Conceptually simple and conservative
• Directly tied to shareholder cash returns
• Works well for stable, income-focused businesses
• Encourages focus on payout sustainability

Dividend Discount Model Disadvantages

• Not applicable to non-dividend-paying companies
• Penalizes businesses that reinvest or use buybacks (very important)
• Highly sensitive to dividend growth assumptions
• Can underestimate value in capital-light or growth-oriented firms

Comparable Companies - Multiples Approach

While stock screening helps identify companies worth monitoring more closely, comparable company analysis helps put those multiples/ratios into context. Multiples allow investors to see how a stock is priced relative to similar businesses within the same industry. Instead of asking what a company is worth in absolute terms, this approach asks a different question:how is the market valuing this business compared to its competitors?

Commonly used multiples include Price-to-Earnings (P/E), Enterprise Value to EBITDA (EV/EBITDA), and Price-to-Free-Cash-Flow. These ratios are often used during screening, but their real value comes when they are applied with an understanding of business quality, growth prospects, and capital structure. A stock trading at a lower multiple than its peers may appear attractive, but that discount often exists for a reason.

Comparable analysis reflects current market sentiment and what investors generally believe about an industry. It can help highlight potential mispricings, but it can also reinforce crowd thinking. For this reason, multiples are best used as a reference point, not as a standalone valuation method.

Comparable Companies – Advantages

• Simple and easy to apply
• Useful for comparing businesses within the same industry
• Effective as a cross-check against other valuation models

Comparable Companies – Disadvantages

• Does not estimate intrinsic value
• Assumes peers are correctly priced by the market
• Can justify overvaluation during bull markets
• Ignores differences in business quality (finding 2 or more similar companies solving the same problem is really hard)

Valuation models are tools, not answers.

Each valuation method offers a different perspective, and relying on only one increases the risk of missing important factors. The most robust approach - and my preference - is to combine multiple methods, understand their limitations, and focus on whether the current price leaves room for error (as discussed earlier with margin of safety).

Valuation is always an attempt to think about the future, but its real purpose is more practical: avoiding the mistake of paying a price that leaves no room for things to go wrong.

Up Next — Chapter Six: The psychology behind value investing

Next, we’ll explore the psychology behind value investing: why patience and temperament often matter more than IQ, how market overreactions and behavioral biases influence decisions, and the common mistakes investors make - buying “cheap” but weak companies, ignoring management, selling too early, or chasing hype. If you want to strengthen your investor mindset, this chapter is a must-read.

To Be Continued

This was Chapter Five of theValue Investing Guide.
If you haven’t read Chapter Four, click the button below to learn about How to Find Undervalued Stocks: Practical Value Stock Screening Guide

Or, if you want to start from the beginning here's a place to start: Investing with Reason: How Engineering Led Me to Value Investing