Valuation Methods Compared: DCF vs Multiples and When to Use Each

Introduction

Valuation Methods Compared: DCF vs Multiples explains two core approaches investors use to estimate a company's value: discounted cash flow (DCF) analysis and valuation by multiples (relative valuation). Both aim to answer the same question, what is a business worth?, but they take different paths to get there.

This matters to investors because the chosen method affects sensitivity to assumptions, comparability across companies, and the insight you gain about drivers of value. In this article you will get a clear recap of how DCF and multiples work, side-by-side pros and cons, concrete examples using real tickers, and practical rules for when to use each method.

• DCF calculates intrinsic value from projected cash flows and is best when cash flow forecasts and a stable discount rate are credible.
• Multiples (comparables) value a company relative to peers using ratios like EV/EBITDA or P/E and are efficient for quick, market-consistent checks.
• Use DCF for capital-intensive firms, turnarounds, or unique earnings profiles; use multiples for mature firms with many comparable peers or when modeling uncertainty is high.
• Key inputs: DCF needs reliable FCF forecasts, an appropriate discount rate (WACC), and a defensible terminal growth rate; multiples require careful peer selection and normalization of accounting differences.
• Combining methods, triangulation, gives a range of reasonable values and helps spot model error or market mispricing.

How DCF Works (Discounted Cash Flow)

DCF estimates intrinsic value by projecting a company’s free cash flows (FCF) into the future and discounting those cash flows back to present value using a discount rate, typically the weighted average cost of capital (WACC). The model usually has an explicit forecast period (3, 10 years) and a terminal value that captures all cash flows beyond the forecast window.

Key components are forecasted revenue growth, operating margins, capital expenditures, working capital changes, WACC, and the terminal growth rate. Small changes in WACC or terminal growth often cause large swings in value, so sensitivity analysis is essential.

Step-by-step DCF process

1. Project revenues and derive operating profit, taxes, and free cash flow for an explicit period (e.g., 5 years).
2. Estimate WACC as the discount rate: cost of equity (CAPM) weighted with after-tax cost of debt.
3. Calculate the terminal value using a perpetual growth model (Gordon Growth) or an exit multiple.
4. Discount the explicit period FCF and terminal value to present value and sum them to get enterprise value.
5. Adjust for net debt and divide by shares outstanding to get equity value per share.

Example: Simplified DCF for an illustrative company ($AAPL-style)

Assume an illustrative company with current FCF of $10B and a 5-year FCF growth profile: Year 1 +6%, Year 2 +6%, Year 3 +5%, Year 4 +4%, Year 5 +3%. Use WACC = 8% and terminal growth g = 2%.

Compute year-by-year FCF, discount at 8%, calculate terminal value at the end of year 5 as FCF5*(1+g)/(WACC-g), discount that back, then sum PVs. If the resulting enterprise value minus net debt yields an equity value of $520B and shares outstanding = 4B, implied equity value per share = $130. This example is illustrative, not a recommendation, and highlights how terminal assumptions and WACC drive the outcome.

How Valuation by Multiples Works (Comparables)

Relative valuation uses market multiples from comparable companies or precedent transactions to infer value. Common multiples include price-to-earnings (P/E), enterprise value-to-EBITDA (EV/EBITDA), and EV/Sales. Multiples convert a single financial metric into an implied enterprise or equity value.

The approach's strength is speed and market anchoring: it shows what the market pays for a dollar of earnings, EBITDA, or sales in a peer group. Its weakness is dependence on selecting appropriate peers and adjusting for accounting or capital-structure differences.

Step-by-step multiples process

1. Choose the metric (e.g., EBITDA, EPS) and the multiple type (EV-based for enterprise value, equity-based for P/E).
2. Select a peer group with similar industry, growth, margins, and risk profile.
3. Calculate the peer median or mean multiple and apply it to the target's metric to get implied value.
4. Adjust for non-operating items, convertible securities, and differences in accounting before finalizing implied equity value.

Example: Multiples for a mature software firm ($MSFT-style)

Suppose a peer group has a median EV/EBITDA of 14x. If the target reports EBITDA of $60B, implied enterprise value = 14 * $60B = $840B. Subtract net cash of $150B to get implied equity value = $690B. Divide by shares outstanding (e.g., 7B) to get implied share price = $98. This shows how multiples translate a single metric into value quickly and transparently.

Side-by-Side Comparison: Strengths, Weaknesses, and Use Cases

Both methods have trade-offs that make them better suited to different scenarios. DCF is theoretically grounded and flexible, but highly assumption-sensitive. Multiples are simpler and market-informed but can miss firm-specific fundamentals.

Use cases:

• When to prefer DCF: unique business models, companies with irregular profitability, investments where understanding cash-generation drivers matters (e.g., capital-intensive or long-cycle businesses), or when you want to model specific operational changes.
• When to prefer multiples: peer-rich industries with standardized metrics (consumer goods, retail), quick screening, or when market sentiment is a key input (valuing a company in a hot sector where investor sentiment drives price).
• When to combine both: triangulate, use multiples as a sanity check for your DCF and vice versa. Large divergence suggests re-check assumptions or consider additional scenarios.

Practical guidance on input selection

Discount rate (WACC): Validate with comparable companies’ betas and firm capital structure. Typical WACC ranges: 6, 10% for lower-risk large-cap companies, 8, 12% for mid-cap, and higher for smaller or riskier firms. Terminal growth: keep it conservative, often between long-term GDP growth and inflation (0, 3%).

For multiples, normalize earnings for one-offs, use forward multiples when forecasts are reliable, and prefer EV-based multiples (EV/EBITDA, EV/FCF) when capital structure differs across peers.

Real-World Examples and Walkthroughs

Example 1, High-growth tech vs. mature industrial. A high-growth software company ($NFLX-style) may have volatile profits but rapid revenue growth. DCF lets you model early reinvestment and later margin expansion; multiples may overstate value if peers are more mature or have different margin profiles.

Example 2, Commodity or cyclical firm. For an industrial materials firm or airline, earnings swing with cycles. Multiples based on recent year EBITDA can be misleading in a cycle peak or trough. Here, DCF that averages normalized FCF over cycles or uses cyclically adjusted metrics gives a clearer picture.

Integrated example: Suppose $XYZ (illustrative) has EBITDA = $5B and net debt = $10B. Peer median EV/EBITDA = 8x gives EV = $40B and equity value = $30B. A DCF with 5-year FCF summing to PV = $28B and terminal PV = $6B gives enterprise value $34B; after net debt, equity = $24B. The range ($24B, $30B) identifies model uncertainty and prompts sensitivity checks on WACC, terminal growth, or peer selection.

Common Mistakes to Avoid

• Over-reliance on a single method: Use both DCF and multiples to triangulate value. Relying on only one approach increases model risk.
• Poor peer selection for multiples: Choosing peers with different growth profiles, margins, or business mix distorts implied multiples. Always normalize and justify the peer set.
• Unrealistic terminal assumptions in DCF: Terminal growth rates above long-term GDP or inflation often inflate terminal value unrealistically. Keep terminal growth conservative (0, 3%).
• Ignoring capital structure and non-operating items: Failing to convert between EV and equity value correctly (or forgetting minority interests, pensions, or excess cash) leads to incorrect per-share values.
• Not stress-testing sensitivity: Small changes in WACC, terminal growth, or multiples can swing valuations. Build sensitivity tables and scenario analyses to understand ranges.

FAQ

Q: When should I use EV/EBITDA instead of P/E?

A: Use EV/EBITDA when capital structure and tax situations differ across peers or when comparing companies with different depreciation/amortization profiles. P/E is equity-based and affected by leverage and non-operating items, while EV/EBITDA compares enterprise operating performance independent of financing.

Q: How do I pick a discount rate for DCF?

A: The typical approach is WACC = (E/V)*Re + (D/V)*Rd*(1-Tax). Estimate cost of equity using CAPM (Re = Risk-free rate + beta*(equity risk premium)) and cost of debt from company yields. Cross-check against peers and use sensitivity ranges ±1, 2%.

Q: What if peer multiples are wildly different, how do I proceed?

A: Investigate why: growth rates, margins, leverage, or accounting differences. Segment peers into more comparable subsets, normalize earnings for one-offs, or place less weight on outliers. Consider using an average of medians across subsets or reverting to DCF where peers are inappropriate.

Q: Can I use a DCF for companies with negative earnings or cash flow?

A: Yes. DCF can be more appropriate than multiples when earnings are negative or volatile, because you can model the expected path back to positive FCF. However, forecasts for early-stage or loss-making firms carry high uncertainty, use scenario analysis and wider sensitivity ranges.

Bottom Line

DCF and multiples are complementary tools: DCF gives insight into intrinsic value driven by a company’s cash flows and assumptions, while multiples provide a market-based, quick benchmark. Neither is perfect; each has contexts where it shines and where it falters.

Practical next steps: build a simple 5-year DCF with sensitivity tables, construct a peer group for relevant multiples, and compare results. Use the differences as signals to re-examine assumptions, not as absolute truth. Over time, combining both approaches will improve your valuation intuition and investment analysis rigor.