Two Approaches — Intrinsic and Relative Valuation

Damodaran's organizing framework: there are exactly three approaches to valuing any asset. Intrinsic valuation anchors on the cash flows the asset will generate over its life, discounted at a rate that reflects their riskiness. Relative valuation anchors on what comparable assets trade for in the market today. Asset-based valuation anchors on what the assets could be sold for individually. Most practitioners use all three, triangulate between them, and investigate when they disagree rather than mechanically averaging the outputs.

Intrinsic valuation is built on a single principle: an asset is worth the present value of all the cash flows it will generate over its life, discounted at a rate that reflects those cash flows' riskiness. This principle is mathematically rigorous and economically sound. It treats every business as a bond with uncertain cash flows — the challenge is estimating those cash flows honestly.

• The fundamental DCF formula: Value = CF₁/(1+r)¹ + CF₂/(1+r)² + CF₃/(1+r)³ + ... + CFₙ/(1+r)ⁿ + Terminal Value/(1+r)ⁿ. Every element of this formula is estimable from financial statements, industry analysis, and historical patterns. The challenge is not the math — it is the honesty of the inputs.
• What counts as a 'cash flow' depends on who you are valuing for: Free Cash Flow to the Firm (FCFF) values the entire enterprise (debt + equity); Free Cash Flow to Equity (FCFE) values only the equity claim. The discount rate must match: WACC for FCFF, cost of equity for FCFE. Mixing them — discounting FCFF at cost of equity — is one of the most common valuation errors.
• Terminal value's dominance: in most practical DCF models, the terminal value (representing the business's value beyond the explicit forecast period) accounts for 60–80% of the total estimated value. This means the assumptions embedded in the terminal value calculation — primarily the long-run growth rate — dominate the model's output. A DCF is often, in practice, mostly a bet on the terminal value assumptions.
• Damodaran's criticism of 'hockey stick' forecasts: most analysts project declining-but-still-elevated margins and above-average growth rates out to year 10, then assume a sudden return to industry-average returns at year 11. This creates the characteristic hockey stick shape in most banker DCF models — artificially inflated by projecting above-average economics for longer than is plausible.

Relative valuation does not ask what a business is intrinsically worth — it asks what the market is currently paying for comparable businesses. If Apple trades at 28× earnings and similar technology companies trade at 25×, one can argue Apple is slightly expensive relative to peers. Relative valuation is faster, simpler, and far more commonly used in practice than DCF — which is precisely why its limitations matter so much.

Damodaran's practical guidance: use both approaches, triangulate between them, and investigate the gap when they disagree. A DCF saying $80 and comps saying $120 is not a reason to average to $100 — it is a prompt to understand what assumption in the DCF differs from the market's implied belief, and to decide which view you think is more correct.

• Use DCF when: you want a market-independent view of value; you are valuing a company in a sector where the entire peer group may be mispriced; you are a long-term investor whose return horizon allows value to be realized; you want to understand what growth and margin assumptions are baked into the current price (the 'reverse DCF' technique).
• Use comps when: you need a quick sanity check against market reality; you are pricing an IPO and need to establish a market-clearing price; you are advising on an M&A transaction where precedent transaction multiples set market expectations; you want to identify which stocks in a sector are cheap or expensive relative to peers.
• Use asset-based valuation when: the business's assets can be readily sold for known prices (real estate, investment portfolios); you are analyzing a liquidation scenario; you are valuing a holding company or conglomerate where individual business units can be independently valued; the going-concern value is questionable.
• The triangulation discipline: practitioners at the best investment banks, hedge funds, and value investing firms run all three approaches and present a range. When DCF and comps disagree, the analyst must explain which assumptions drive the gap — not suppress one answer. Disagreement between methods is information, not inconvenience.