How to value a stock: multiples and discounted cash flow

Valuing a stock means estimating what the business is worth and comparing it with what the market asks. There is no exact value: every figure depends on assumptions. That is why two complementary approaches are used — multiples and discounted cash flow (DCF) — and why investors look for a margin of safety. We continue with the fictional Example Corp, trading at $9.90 a share.

  • Multiples compare the price with earnings, EBITDA or cash, against the company's history and peers.
  • DCF adds up the present value of the cash the company will generate.
  • DCF is very sensitive to the discount rate and growth: always test several scenarios.
  • Use both methods to cross-check and only buy with a margin of safety.
  • Enterprise value (EV) includes debt: use it to compare companies with different leverage.

Method 1: multiples

Multiples relate the price to a business metric. For Example Corp (100 million shares, $990M market cap, $400M net debt):

How to use multiples

A multiple on its own says nothing. Compare it:

  • With peers: if similar companies trade at 10x EV/EBITDA and Example Corp at 7.7x, it may be cheap — or have a problem that justifies the discount.
  • With its history: is it above or below its 10-year average?
  • With its growth and quality: higher ROIC and growth deserve higher multiples.

EV/EBITDA is preferable to P/E when companies have very different debt levels, because enterprise value includes debt. See P/E ratio.

Method 2: discounted cash flow

A DCF estimates free cash flow for the coming years and brings it back to today with a discount rate that reflects risk. Assumptions for Example Corp:

  • Current FCF: $70M, growing 5% a year for 5 years.
  • From year 6, perpetual growth of 2%.
  • Discount rate: 8%.

Sensitivity: the big limitation of DCF

With these assumptions, the estimated value ($9.56) is close to the price ($9.90): the stock does not look cheap. But small changes in the assumptions move the result a lot:

Margin of safety

Because valuation is a range, not a number, prudent investors only buy when the price is clearly below their estimate — for example by 20–30%. For Example Corp, with a central value of $9.56, an attractive price would be below about $7–7.50.

The margin of safety protects you from forecasting errors, which always exist.

Frequently asked questions

What is the best way to value a stock?

There is no single best method. Multiples are quick and comparative; DCF forces you to think about future cash. Using both is the most sensible approach.

Which discount rate should I use?

The return you would require for the company's risk. For mature companies, 7–10% is common; higher for more uncertain businesses.

What is enterprise value (EV)?

Market capitalisation plus net debt — what it would cost to buy the whole business, including its debt.

What is a margin of safety?

The gap between estimated value and purchase price. Buying at a discount protects you if your forecasts are too optimistic.