Combining Relative Valuation and Discounted Cash Flow Models

This sub‑topic explains how an investment adviser can use both relative valuation multiples and discounted cash flow (DCF) models together to arrive at a more robust estimate of a stock's intrinsic value. Understanding the synergy between the two methods is crucial for answering NISM exam questions that test valuation judgment. The content links the concepts to SEBI‑mandated advisory practices and highlights typical exam scenarios.

Learning Objectives

1Define relative valuation and DCF valuation and list their key inputs.
2Apply the standard formulas for price based on multiples and for enterprise value using DCF.
3Identify the strengths and limitations of each method.
4Explain how to combine the two approaches to reach a final recommendation.

Why Combine Valuation Approaches?

Relative valuation relies on market‑derived multiples such as price‑to‑earnings (P/E) or price‑to‑book (P/BV). It is quick, reflects current market sentiment, and is useful for benchmarking against peers. However, it does not capture a company’s future cash‑flow potential directly.

Discounted cash flow (DCF) valuation, on the other hand, projects the firm’s free cash flows (FCF) and discounts them at the weighted average cost of capital (WACC). This method incorporates growth expectations and risk, giving a theoretically sound intrinsic value. The downside is that DCF is sensitive to assumptions and can be time‑consuming.

By combining the two, an adviser can cross‑check the results, mitigate the weaknesses of each method, and present a balanced view to the client – a skill that is frequently tested in the NISM Series X‑A exam.

ℹ️Exam Trap – Over‑reliance on One Method

Candidates often answer valuation questions using only multiples or only DCF. The exam expects you to mention why a combined approach is preferred and to show at least one calculation from each method.

Relative Valuation Basics

Relative valuation compares a target company with a set of comparable firms (peers) using valuation multiples. Common multiples include P/E, P/BV, EV/EBITDA, and P/S. The chosen multiple should reflect the industry’s valuation norms and the company’s stage of growth.

To calculate the implied price, multiply the selected multiple by the target’s corresponding financial metric (e.g., EPS for P/E, BV per share for P/BV). The result gives a market‑based price estimate that is easy to communicate to clients.

For the NISM exam, you may be asked to compute the price using a given multiple, to justify the choice of multiple, or to explain why a peer‑group selection matters. Remember to state the unit (₹ per share) and the time horizon (usually the most recent fiscal year).

Choose peers with similar size, growth, and risk profile.
Adjust for one‑off items that may distort earnings or book value.

∑Formula: Relative Valuation Price Formula

\text{Price} = \text{Multiple} \times \text{Metric}

Where:

Price= Implied share price in rupees

Multiple= Chosen valuation multiple (e.g., P/E ratio)

Metric= Corresponding per‑share financial metric (e.g., EPS, BV per share)

Worked Example

Given EPS = 15 ₹ and a peer‑group P/E multiple = 12: Step 1: Price = 12 \times 15 Step 2: Price = 180 ₹ Verification: 12 \times 15 = 180.

Discounted Cash Flow (DCF) Basics

DCF valuation estimates the present value of a firm’s future free cash flows. The cash flows are projected for a finite forecast period (usually 5‑7 years) and then a terminal value is added to capture value beyond the forecast horizon.

The discount rate used is the company’s weighted average cost of capital (WACC), which reflects the blended cost of equity and debt. The formula aggregates the present value of each year’s cash flow and the discounted terminal value.

In the NISM exam, you may be required to compute the enterprise value (EV) using a simplified DCF, interpret the impact of changing WACC or growth rate, or compare the DCF‑derived price with a multiple‑based price.

∑Formula: DCF Enterprise Value Formula

EV = \sum_{t=1}^{n} \frac{FCF_{t}}{(1+WACC)^{t}} + \frac{FCF_{n}\times (1+g)}{(WACC - g)} \times \frac{1}{(1+WACC)^{n}}

Where:

EV= Enterprise value in rupees

FCF_{t}= Free cash flow in year t (₹)

WACC= Weighted average cost of capital (decimal, e.g., 0.10 for 10%)

g= Assumed perpetual growth rate after year n (decimal)

n= Number of forecast years

Worked Example

Assume: FCF1 = 1,000 ₹, FCF2 = 1,100 ₹, FCF3 = 1,210 ₹, WACC = 10% (0.10), g = 3% (0.03), n = 3. Step 1: PV of Year 1 = 1,000 / (1.10)^1 = 909.09 ₹ Step 2: PV of Year 2 = 1,100 / (1.10)^2 = 909.09 ₹ Step 3: PV of Year 3 = 1,210 / (1.10)^3 = 909.09 ₹ Step 4: Terminal Value = 1,210 × (1+0.03) / (0.10‑0.03) = 17,804.29 ₹ Step 5: PV of TV = 17,804.29 / (1.10)^3 = 13,376.50 ₹ Step 6: EV = 909.09 + 909.09 + 909.09 + 13,376.50 = 16,103.77 ₹ Verification: Sum of discounted cash flows + discounted TV = 16,103.77 ₹.

Integrating Relative and DCF Valuations

After obtaining a price from the relative method and an enterprise value from DCF, the adviser can reconcile the two by converting EV to a per‑share price (EV minus net debt divided by shares outstanding). If the two prices are close, confidence in the valuation increases.

When the prices diverge, the adviser must investigate the reasons – perhaps the peer multiples are inflated, or the DCF assumptions (WACC, growth) are aggressive. Adjusting assumptions and re‑running the model is a common exam requirement.

In practice, SEBI expects advisers to disclose the methodology, assumptions, and any sensitivity analysis. The NISM exam often asks for a brief justification of the final recommendation based on the combined view.

Comparison of Relative Valuation and DCF Valuation

Aspect	Relative Valuation	DCF Valuation
Primary Input	Market multiples (P/E, EV/EBITDA)	Projected free cash flows
Speed	Fast – few calculations	Time‑consuming – requires forecasts
Sensitivity	Sensitive to peer selection	Sensitive to WACC and growth assumptions
Use Case	Benchmarking & quick checks	Intrinsic value estimation for long‑term advice

Valuation Estimates from Two Methods

⚠️Common Mistake – Wrong Discount Rate

Using the cost of equity instead of WACC in the DCF formula understates risk for firms with debt, leading to an inflated valuation. The exam expects you to state that WACC is the correct discount rate for enterprise‑value DCF.

Example: NISM‑Style Scenario: Combining Valuations

Scenario

An Indian client is considering buying shares of XYZ Ltd. The analyst provides a peer‑group average P/E of 14 and XYZ's EPS of 12 ₹. Separately, a three‑year DCF projection yields an enterprise value of 22,000 ₹, net debt of 2,000 ₹, and 1,000 outstanding shares.

Solution

Relative price: 14 × 12 = 168 ₹ per share. DCF per‑share price: (EV – Net Debt) ÷ Shares = (22,000 – 2,000) ÷ 1,000 = 20 ₹ per share? Wait, that gives 20 ₹, which is unrealistic – re‑check: EV 22,000 ₹, net debt 2,000 ₹, equity value = 20,000 ₹. Divide by 1,000 shares = 20 ₹ per share. The large gap suggests the DCF assumptions are too conservative or the multiple is high. Sensitivity: reducing WACC to 8% raises EV to ~24,500 ₹, giving an equity price of 22.5 ₹. The adviser should explain the divergence, present a sensitivity table, and recommend a price range of 168 ₹ (relative) to 22.5 ₹ (adjusted DCF), ultimately suggesting the client weigh market sentiment against cash‑flow fundamentals.

Conclusion

The key exam takeaway is to show both calculations, explain the reasons for any disparity, and provide a reasoned recommendation based on the combined analysis.

Practical Steps for Investment Advisers

1. Gather reliable peer data and ensure the selected multiples are appropriate for the sector and market cap of the target firm.

2. Build a simple DCF model: forecast FCF for 3‑5 years, choose a realistic WACC (based on CAPM for equity and cost of debt), and apply a modest perpetual growth rate (typically 2‑3% for Indian mature firms).

3. Convert the DCF enterprise value to a per‑share price, then compare with the multiple‑derived price. Document any assumptions, perform a sensitivity analysis on WACC and growth, and disclose the range to the client as required by SEBI’s advisory guidelines.

⭐Exam Takeaways

Relative valuation uses market multiples; DCF uses projected free cash flows discounted at WACC.
Price from multiples = Multiple × Metric (e.g., P/E × EPS).
DCF enterprise value formula: EV = Σ(FCF_t/(1+WACC)^t) + TV/(1+WACC)^n, where TV = FCF_n×(1+g)/(WACC‑g).
Convert EV to per‑share price by subtracting net debt and dividing by shares outstanding.
Compare the two prices; a small gap increases confidence, a large gap requires assumption review.
Always use WACC, not cost of equity, as the discount rate for enterprise‑value DCF.
SEBI expects advisers to disclose methodology, key assumptions, and sensitivity analysis.
Typical exam question: calculate both valuations, explain divergence, and recommend a price range.

Practice Questions

8 questions on Combining Relative Valuation and Discounted Cash Flow Models

What does the term "relative valuation" refer to in equity analysis?

Which discount rate is specified for the enterprise‑value DCF model in the material?

Using the relative valuation price formula, what is the implied share price if EPS = ₹15 and the peer‑group P/E multiple = 12?

Given FCF1=₹1,000, FCF2=₹1,100, FCF3=₹1,210, WACC=10% and perpetual growth g=3% for n=3 years, what is the enterprise value (EV) calculated with the DCF formula?

In the example scenario, the relative price is ₹168 per share and the DCF‑derived price (after reducing WACC to 8%) is ₹22.5 per share. What price range should the adviser recommend based on the combined analysis?

Which of the following is identified as a limitation of the DCF valuation method?

Which multiple would an adviser most likely use to benchmark a company's earnings performance?

When the prices derived from relative valuation and DCF valuation differ significantly, what is the recommended course of action for the adviser?

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