There are many techniques that are used to value a company. However, if you’d take the time to look through all the different models and fancy footwork that investors use to crunch the numbers and pin down the value of a company, you might realize that they generally fall into two main categories: 1) A discounted cash flow valuation method; and 2) a relative valuation method.

The discounted cash flow model

At its simplest, the value of a company is the sum of all the cash a company can generate for its shareholders that’s discounted back to the present – that’s the basis for the discounted cash flow model. Let’s use the land transport outfit ComfortDelGro Corporation (SGX: C52) as an example.

The company has been generating about S\$700 million in cash from its operations in each of the past two years. It had then spent about S\$500 million each year to reinvest in its business. This thus produces an annual free cash flow of around S\$200 million for its shareholders. If I assume that ComfortDelGro is able to produce a consistent free cash flow of S\$200 million for the rest of its foreseeable future, I can then discount each year’s free cash flow at an appropriate discount rate to obtain their present value. When I sum all that up, I would obtain the intrinsic value of the company. This is the basic idea behind a discounted cash flow model.

The relative valuation model

A relative valuation method is used widely in the world of finance. This is because the data that’s required is extremely easy to obtain and it gives investors a quick-and-dirty way to compare the relative cheapness between two or more companies. Typical relative valuations are the Price to Earnings Ratio (P/E), Price to Book Ratio (P/B) and Price to Sales Ratio (P/S).

For an idea of how the P/E ratio works, we can use the banking industry as an example.

By dividing DBS Group Holdings’ (SGX: D05) current share price of S\$16.84 with its trailing earnings per share of S\$1.61, we can see that the bank is trading at a P/E ratio of 10.4 times. We can then compare DBS’ P/E ratio with that of Oversea-Chinese Banking Corporation (SGX: O39) and United Overseas Bank (SGX: U11); the other two banks both have a P/E ratio of 11.5 at their current prices of S\$9.69 and S\$22.53 respectively. Assuming everything else’s constant, DBS could then be said to have the cheaper valuation in relation to OCBC and UOB. This is how a relative valuation method can give us a great way to compare companies within the same industry.

Foolish Summary

Although there are many other factors to consider when making an investment, understanding the two major type of valuation methodologies can definitely help give you an edge when deciding upon our next investment.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.