Market Signals Daily.

Deep Dive: Valuation Models for the Modern Investor (2025 Edition)

CuriousFolk

"Price is what you pay. Value is what you get." — Warren Buffett.

This quote is the cornerstone of intelligent investing. Yet, 90% of market participants cannot tell you the difference between Price and Value. They assume that if a stock is $100, it is "worth" $100.

This is a dangerous fallacy. The market is a voting machine in the short term (driven by emotion) and a weighing machine in the long term (driven by value). To make money, you must identify when the voting machine is wrong. You must find the $100 bills selling for $50.

But how do you determine that a stock is "worth" $100?

At CuriousFolk, we believe that valuation is not magic; it is math. In this advanced guide, we will move beyond the simple P/E ratio. We will build Discounted Cash Flow (DCF) models, explore Relative Valuation techniques, and teach you how to bake a Margin of Safety into every trade to protect yourself from your own stupidity.

1. The Philosophy of Value

Before we open Excel, we must agree on a definition: The value of any financial asset is the present value of all its future cash flows.

Whether it is a bond, a house, or a stock, it is worth the cash it will put in your pocket between now and Judgment Day, discounted by the "cost" of waiting for that money.

The Time Value of Money

A dollar today is worth more than a dollar tomorrow. Why?

  1. Inflation: Purchasing power erodes.
  2. Opportunity Cost: You could invest that dollar in a risk-free asset (like a Treasury Bond) and earn interest.

Therefore, we must "discount" future cash flows to determine what they are worth today.

2. The Discounted Cash Flow (DCF) Model

This is the gold standard of valuation. It is theoretically perfect, but practically difficult because it relies on assumptions about the future.

The Formula

Value = Sum of [ FCF / (1 + r)^n ] + Terminal Value

  • FCF: Free Cash Flow (Cash generated by operations minus CapEx).
  • r: Discount Rate (Your required rate of return, usually the WACC).
  • n: The year number.

Step-by-Step CuriousFolk DCF Guide

Let's value a hypothetical lemonade stand: "LemonCorp."

  1. Estimate Future Growth: LemonCorp made $100 in FCF last year. We assume it grows 5% for the next 5 years.
  2. Determine Terminal Value: After year 5, we assume it grows at 2% forever (inflation rate).
  3. Choose a Discount Rate: Since lemonade stands are risky, we demand a 10% return (r = 0.10).
  4. Calculate:
    • Year 1: $105 / 1.10 = $95.45
    • Year 2: $110.25 / 1.21 = $91.11
    • ... (Sum them up)

CuriousFolk Insight: Small changes in the Discount Rate cause massive changes in valuation. In 2022, when the Fed raised rates (increasing r), the value of Tech Stocks (whose cash flows are far in the future) collapsed mathematically.

3. Relative Valuation: The "Comparables" Method

If DCF is science, Relative Valuation is art. It involves comparing a company to its peers or its own history.

The P/E Ratio (Price-to-Earnings)

  • Formula: Price / EPS.
  • Use Case: Best for mature, profitable companies.
  • Trap: Cyclical companies (like Oil) have low P/Es at the top of the cycle (peak earnings) and high P/Es at the bottom. Buying a low P/E oil stock is often a mistake.

The P/S Ratio (Price-to-Sales)

  • Formula: Market Cap / Revenue.
  • Use Case: Best for unprofitable growth stocks (SaaS).
  • CuriousFolk Rule: A P/S > 10 is rare air. A P/S > 20 is historically a bubble. At 20x sales, the company must grow at 40% for 10 years just to justify the price.

The PEG Ratio (Price/Earnings-to-Growth)

Popularized by Peter Lynch. It adjusts the P/E for growth.

  • Formula: (P/E Ratio) / (Annual EPS Growth Rate).
  • Target: A PEG of 1.0 is "Fair Value." Under 1.0 is "Undervalued."
  • Example: A stock with a P/E of 30 growing at 30% has a PEG of 1.0. A stock with a P/E of 15 growing at 5% has a PEG of 3.0 (Overvalued!).

4. The Sum-of-the-Parts (SOTP) Analysis

Sometimes, the whole is worth less than the sum of its parts. This is where activist investors make their money.

Example: Amazon. Amazon is not one business. It is:

  1. AWS: A massive cloud monopoly.
  2. Retail: A low-margin e-commerce giant.
  3. Ads: A high-margin advertising platform.

If you value AWS like Microsoft Azure, and Ads like Google, and Retail like Walmart, you might find that Amazon's stock price implies the Retail business is free. This is a buying opportunity.

5. The CuriousFolk "Margin of Safety"

Valuation is imprecise. Your growth assumptions will be wrong. Interest rates will change.

Benjamin Graham, the father of value investing, solved this with the Margin of Safety.

  • Concept: If you calculate the Intrinsic Value is $100, do not buy at $95. Buy at $60.
  • The Buffer: The gap between price and value allows for error. If the stock is actually only worth $80, you still make money buying at $60.

CuriousFolk Risk Tiers:

  • Wide Moat / Stable (Coca-Cola): 10-20% Margin of Safety required.
  • Cyclical / Average (Ford): 30-40% Margin of Safety required.
  • High Growth / Risky (Tesla): 50%+ Margin of Safety required.

6. Historical Data: Valuation Metrics over Time

Is the market expensive right now? Let's look at the "Shiller P/E" (CAPE Ratio), which smooths earnings over 10 years to adjust for cycles.

Table 1: S&P 500 Valuation Regimes

Era Average CAPE Ratio Subsequent 10-Year Return (Annualized)
Dotcom Bubble (2000) 44.2 (Extreme) -0.9% (Lost Decade)
Financial Crisis (2009) 13.3 (Cheap) +13.2% (Great Bull Run)
Covid Peak (2021) 38.6 (Expensive) TBD (Likely Low)
Historical Average 17.0 +8-10%

CuriousFolk Insight: Valuation is a terrible timing tool (markets can stay expensive for years) but an excellent predictor of long-term returns. Buying high guarantees low future returns.

7. The Reverse DCF: A Reality Check

Instead of guessing the growth rate, ask: "What growth rate is the market pricing in?"

If a stock trades at $100, run the DCF backwards. "For the stock to be worth $100, it must grow at 15% for 10 years." Then ask: "Is it realistic for a refrigerator company to grow at 15%?" If the answer is "No," the stock is overvalued. This removes your bias from the equation.

8. Frequently Asked Questions (FAQ)

Q: Which valuation method is best? A: None. Use a "Triangulation" approach. Run a DCF, check the P/E relative to peers, and do a Sum-of-the-Parts. If all three say "Cheap," buy. If they disagree, investigate.

Q: Why do expensive stocks keep going up? A: Momentum and Hype. In the short term, price is driven by liquidity. In the long term, gravity (valuation) always wins.

Q: Can a stock be undervalued forever? A: Yes. This is a "Value Trap." For the value to be unlocked, there usually needs to be a Catalyst (Buyback, Acquisition, Management Change, Earnings Surprise).

9. Conclusion: The Price of Discipline

Valuation is the discipline of saying "No." "No" to the hot stock everyone is talking about. "No" to the company with a great story but 100x earnings.

It is painful to sit on the sidelines while others make easy money in a bubble. But remember the Tortoise and the Hare. The investor who buys a dollar for 50 cents will eventually own the market.

At CuriousFolk, we are not speculators; we are appraisers. We buy value, we wait for the market to agree with us, and we profit from the correction of error.

Disclaimer: This article is for educational purposes only. Valuation involves subjective assumptions.