📚 PASS Investment Adviser (Level 1) Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 8.6 — Combining Relative Valuation And Discounted Cash Flow Models

Imagine you are an analyst covering a mid-cap IT firm listed on the NSE. You have spent the morning fine-tuning your DCF model, but as the broader market experiences a sharp correction due to global geopolitical tensions, the stock price has decoupled from your intrinsic value estimate. You face a dilemma: your valuation model suggests the stock is a ‘buy’ based on long-term cash flow potential, yet the market is aggressively compressing the stock’s Price-to-Earnings (P/E) multiple.

This is the moment where theory must bow to the reality of sentiment-driven volatility.

In volatile Indian markets, reliance solely on a static DCF model can be dangerous because the inputs—specifically the Weighted Average Cost of Capital (WACC)—are sensitive to interest rate fluctuations and risk premiums. During periods of high uncertainty, market participants often abandon fundamental growth projections in favor of immediate liquidity and defensive positioning. Consequently, historical valuation multiples can contract sharply, reflecting ‘fear’ rather than a fundamental shift in the company’s underlying business capacity or cash-generating ability.

To navigate this, professional analysts utilize ’normalized’ multiples rather than current spot-price multiples. By observing a company’s P/E or EV/EBITDA over a five-year cycle, you can identify whether the current contraction is an outlier driven by transient market panic or a permanent impairment of value. If the company’s operating margins remain stable while the sector-wide valuation multiple compresses, it often signals an opportunity to build a position for a patient investor, provided the cash flow trajectory remains intact.

Consider the case of a pharmaceutical giant in the Nifty 50. When market volatility hits, investors often rotate out of cyclical sectors and into defensive ones, causing multiples to swing wildly. An analyst who blindly uses the current depressed multiple to determine an ’exit price’ may lock in losses, whereas an analyst who integrates the relative valuation with the DCF recognizes that the ‘fair’ multiple must be anchored to the company’s long-term terminal value.

In short, multiples serve as a barometer for current market sentiment, while the DCF serves as the anchor for long-term economic reality.1

Nuance

⚠️ Nuance
The most common pitfall is the ‘falling knife’ fallacy, where candidates assume a shrinking P/E ratio represents an automatic buying opportunity. In reality, a shrinking multiple can accurately reflect a downward revision in expected future earnings growth that the DCF model has not yet fully incorporated. An analyst must ensure their DCF growth assumptions are updated to reflect current economic realities before using a ‘cheap’ historical multiple as a justification for a buy recommendation.

Check Your Understanding

Practice Question 1

During a period of sudden market instability on the BSE, an analyst observes that a high-growth manufacturing firm’s P/E ratio has dropped from 35x to 22x, while the firm’s projected future cash flows remain unchanged. Which approach best addresses this discrepancy?

Practice Question 2

Why might a DCF valuation and a relative valuation based on current market multiples diverge significantly during a market-wide liquidity crunch?

This is a companion read for Section 8.6 — Combining Relative Valuation And Discounted Cash Flow Models from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

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  1. Terminal value represents the present value of all future cash flows beyond the projection period, usually accounting for the majority of a company’s total DCF-based valuation. ↩︎