Stock Valuation Techniques: A Guide to DDM, DCF, and Comparables
By Markets & Investing DeskUpdated Nov 10, 2026
Key takeaways
- The Gordon Growth Model values a share as D1 / (r - g) and breaks down if g equals or exceeds r.
- In the worked DCF example, the terminal value made up about 77% of the company's enterprise value.
- Using P/E requires a listed company, positive earnings and earnings that are stable and not shaped by accounting.
- Comparables cannot show whether an entire peer group is overpriced, which limits every relative method.
Stock valuation techniques fall into two groups. Absolute models estimate what a share is worth from the company’s own cash flows. Relative models judge whether a share is cheap or expensive next to similar companies. The three most widely used are the dividend discount model (DDM) and the discounted cash flow model (DCF), which are absolute, and comparables, which are relative. Which one fits depends mainly on the company: steady dividend payers suit the DDM, firms with positive and predictable free cash flow suit the DCF, and almost any listed company can be run through comparables.
Absolute vs. Relative Valuation
Absolute Valuation
An absolute model tries to find a stock’s intrinsic, or “true,” value using only that company’s fundamentals: its dividends, cash flows and growth rate. Other companies do not enter the calculation. Besides the DDM and DCF, this group includes the residual income model, which values a company from book value plus earnings above the cost of equity, and asset-based valuation, which starts from what the company’s assets are worth net of liabilities.
The output is a dollar figure per share that you can set against the market price. The cost is effort and sensitivity: every result rests on forecasts of growth and a chosen discount rate, and small changes in those inputs can move the answer a long way.
Relative Valuation
A relative model asks a different question: how is this stock priced compared with similar businesses? You calculate a multiple, such as the price-to-earnings (P/E) ratio, and compare it with the same multiple for peers or an industry average. If Company A trades at 12 times earnings and comparable companies trade at 18, Company A may be undervalued, or the market may have a reason for the discount.
Relative valuation is faster because the inputs are a share price and a figure from the financial statements, so many analysts start here and move to an absolute model for the companies that look interesting.
Mechanics of the Dividend Discount Model (DDM)
The DDM is one of the most basic absolute models. Its logic is that dividends are the cash a shareholder actually receives, so the present value of all expected future dividends should equal what a share is worth.
Two checks come before any calculation:
- Does the company pay a dividend? If not, the model cannot be used.
- Is the dividend stable and predictable? Paying a dividend is not enough. The payout needs a pattern you can project forward. Companies that meet this test tend to be mature, blue chip businesses in well-developed industries.
The hypothetical company below shows what a good DDM candidate looks like:
| Hypothetical Company | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 |
|---|---|---|---|---|---|---|
| Dividends per share | $1.00 | $1.04 | $1.08 | $1.12 | $1.17 | $1.22 |
| Earnings per share | $2.50 | $2.60 | $2.70 | $2.81 | $2.92 | $3.04 |
Earnings grow at roughly 4% a year and dividends grow at the same pace. The payout ratio (dividends divided by earnings) stays close to 0.40 every year. A dividend that tracks earnings this closely is easy to forecast, which is exactly what the DDM needs.
The Gordon Growth Model
The most common form of the DDM is the Gordon Growth Model, which assumes dividends grow at a constant rate forever:
Value per share = D1 / (r - g)
- D1 = next year’s expected dividend (this year’s dividend × (1 + g))
- r = the investor’s required rate of return (cost of equity)
- g = the constant dividend growth rate
Using the hypothetical company, with an assumed 4% growth rate and a 9% required return:
- D1 = $1.22 × 1.04 ≈ $1.27
- Value = $1.27 / (0.09 - 0.04) = $1.27 / 0.05 = $25.40
The result is highly sensitive to the gap between r and g. Keeping everything else the same, an 8% required return gives $1.27 / 0.04 = $31.75, while 10% gives about $21.17. A one-point change in one assumption moves the value by roughly 20% or more. The formula also breaks down entirely if g is equal to or greater than r, so the growth rate must be one the company can plausibly sustain indefinitely.
For companies expected to grow quickly for a few years before slowing, analysts use a multi-stage DDM: they forecast individual dividends for the high-growth years, then apply the Gordon formula to the period after growth settles, and discount everything back to today.
Assessing Stocks Using the Discounted Cash Flow (DCF) Model
If a company pays no dividend, or its dividend is irregular, consider the DCF. It discounts the company’s future free cash flow, the cash left after the business pays for operations and investment, so it works for firms that do not pay dividends as well as for those that do.
Free cash flow is commonly calculated from the cash flow statement:
Free cash flow = Operating cash flow - Capital expenditures
The Two-Stage DCF
The DCF has several variations, and the two-stage version is the most widely used. In stage one, you forecast free cash flow year by year, typically for five to 10 years. In stage two, a terminal value captures all cash flows beyond the forecast period, often with the same constant-growth formula used in the Gordon model:
Terminal value = FCF in final year × (1 + g) / (r - g)
Each forecast cash flow and the terminal value are discounted back to today. When the cash flows are free cash flow to the firm (available to both lenders and shareholders), the discount rate is usually the weighted average cost of capital (WACC), and the result is enterprise value. Subtracting net debt gives equity value, and dividing by shares outstanding gives value per share.
A Worked DCF Example
Assumptions (hypothetical, in millions of dollars): free cash flow of $100 next year, growing 8% a year for five years; WACC of 9%; terminal growth of 3%; net debt of $300; 50 million shares.
| Year | Free cash flow | Discount factor at 9% | Present value |
|---|---|---|---|
| 1 | 100.00 | 1.0900 | 91.74 |
| 2 | 108.00 | 1.1881 | 90.90 |
| 3 | 116.64 | 1.2950 | 90.07 |
| 4 | 125.97 | 1.4116 | 89.24 |
| 5 | 136.05 | 1.5386 | 88.42 |
- Present value of years 1 to 5: about $450.4
- Terminal value at year 5: 136.05 × 1.03 / (0.09 - 0.03) ≈ $2,335.5
- Present value of terminal value: 2,335.5 / 1.5386 ≈ $1,517.9
- Enterprise value: 450.4 + 1,517.9 ≈ $1,968.3
- Equity value: 1,968.3 - 300 = $1,668.3
- Value per share: 1,668.3 / 50 ≈ $33.37
In this example the terminal value accounts for about 77% of enterprise value. That pattern follows from the math whenever the forecast period is short and long-run growth is assumed: most of the answer depends on the two assumptions (r and g) that are hardest to know.
When a DCF Does Not Fit
The first requirement is positive, predictable free cash flow. That excludes many small, fast-growing or young companies, because heavy capital spending absorbs their operating cash. Consider this hypothetical firm:
| Hypothetical Company | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 |
|---|---|---|---|---|---|---|
| Operating cash flow | 300 | 550 | 900 | 620 | 1,400 | 450 |
| Capital expenditures | 600 | 700 | 820 | 900 | 1,300 | 1,100 |
| Free cash flow | -300 | -150 | 80 | -280 | 100 | -650 |
Operating cash flow is trending up, but the company reinvests more than it generates in most years. Free cash flow is negative in four of six years and swings widely, so a five- to 10-year forecast would be close to guesswork. The best DCF candidates are mature firms past their growth stage, with stable, positive and predictable free cash flow. For a company like this one, multiples such as price-to-sales are usually the practical alternative.
Applying Comparables for Rapid Stock Valuation
Comparables are the catch-all method: usable when the other models do not fit, or when you want a quick answer without building a forecast. Instead of seeking intrinsic value, the method compares the stock’s price multiples with a benchmark, such as a peer group, an industry average or the company’s own history, to judge whether the stock is relatively cheap or expensive.
The rationale is the Law of One Price: two similar assets should sell for similar prices.
Choosing the Multiple
Comparables work in almost any situation because there are many multiples to choose from:
- Price-to-earnings (P/E): share price divided by earnings per share. The most commonly used, since earnings are a primary driver of value.
- Price-to-book (P/B): share price divided by book value per share. Often used for banks and asset-heavy businesses.
- Price-to-sales (P/S): market value divided by revenue. Usable when earnings are negative.
- Price-to-cash flow (P/CF): share price divided by operating cash flow per share. Less affected by noncash accounting charges than earnings.
- EV/EBITDA: enterprise value divided by earnings before interest, taxes, depreciation and amortization. Useful for comparing companies with different debt levels.
The P/E multiple needs three conditions. The company must be publicly traded, because you need a share price. Earnings must be positive, because a negative P/E carries no meaning. And earnings quality should be good: not too volatile, and not heavily shaped by accounting choices. When those conditions fail, switch to price-to-sales or price-to-cash flow. P/S rests on the top line and P/E on the bottom line (see revenue and profit).
A Worked Comparables Example
Hypothetical inputs: three close peers trade at 15, 17 and 19 times earnings, a median of 17. The target company earns $2.00 per share and trades at $28, a P/E of 14.
- Implied price at the peer median: 17 × $2.00 = $34
- The stock trades about 18% below that figure.
That gap is a starting point, not a verdict. The discount may reflect slower growth, higher debt or weaker margins than the peers. Comparables also cannot tell you whether the whole peer group is overpriced, which is the main limitation of every relative method.
Choosing a Model
| Company profile | Best-suited model | Why |
|---|---|---|
| Mature, steady dividend payer with a consistent payout ratio | DDM | Dividends are predictable and track earnings |
| Mature firm with stable, positive free cash flow, dividend or not | DCF | Cash flows can be forecast with reasonable confidence |
| Growth company with negative or erratic free cash flow | Comparables (P/S, EV/sales) | Forecasting cash flow is unreliable |
| Profitable listed company with clean earnings | Comparables (P/E) alongside DCF | Quick check, then a deeper intrinsic estimate |
| Bank or asset-heavy business | P/B, residual income | Book value is central to the business |
Neither group is better in general. Relative valuation is quicker and anchored to real market prices, but it inherits any mispricing in the peer group. Absolute valuation takes more work and shows what drives value, yet its output can be pushed almost anywhere by the discount rate and growth inputs. Using one of each, and investigating when they disagree, gives a broader view than either alone. For valuing a whole business, including private companies, see business valuation methods.
Why a Stock’s Price Differs From Its Calculated Value
A model’s output is not a forecast of where the price will go. Different investors choose different inputs, and the market price reflects the combined expectations of all buyers and sellers. A stock can trade above a calculated value when investors expect profitability to beat the model’s assumptions, and below it when they fear underperformance or when risks the model does not capture weigh on the shares.
A useful way to read a gap is to ask what the market price implies. Reverse-engineering a DCF (solving for the growth rate that justifies today’s price) shows whether the market’s expectations look reasonable or stretched.
Special Considerations
- Test a range of discount rates. As both worked examples show, a one-point change in r moves the result substantially.
- Terminal growth should be modest. A rate above the long-run growth of the economy implies the company eventually becomes larger than the economy around it.
- Consistency of inputs. Free cash flow to the firm pairs with WACC and produces enterprise value. Cash flow to equity, like dividends, pairs with the cost of equity and produces equity value directly. Mixing them distorts the answer.
- Peer selection decides comparables. Similar size, business mix, growth and leverage matter more than sharing an industry label.
FAQs
Are DCF and DDM the same?
No, although both discount expected future cash flows to the present. The DDM uses only dividends paid to shareholders, while the DCF uses free cash flow, which includes cash the company retains. For a company that pays out nearly all its free cash flow, the two can produce similar values. For one that pays little or no dividend, the DDM understates value or cannot be used, while a DCF still works if free cash flow is positive.
Should relative valuation use book value or market value?
Use market value for the price side of a multiple, meaning the share price, market capitalization or enterprise value. Book value appears as the denominator only in multiples built on it, such as P/B. For enterprise value, debt is often taken at book value because market values for debt are harder to observe.
The Bottom Line
Investors choosing a valuation method should match it to the company: the DDM for steady dividend payers, the DCF for firms with stable positive free cash flow, and comparables for nearly any listed stock. Because absolute results swing with small changes in the discount rate and growth inputs, test a range of assumptions. Pairing one absolute and one relative model, then investigating any disagreement, gives a broader view than either alone.
