Intrinsic vs. Relative Valuation

When you buy a flat in Mumbai, you usually do two things. First, you check the condition of the flat itself — its construction quality, layout, maintenance — to understand if it’s genuinely worth buying. Second, you compare it with the prices of similar flats in the same locality to ensure you are not overpaying. This simple property-buying behaviour perfectly mirrors the two primary approaches to company valuation: intrinsic valuation and relative valuation.

Intrinsic Valuation focuses purely on the fundamentals of the company itself, without being influenced by how other companies are valued. It is like inspecting the flat thoroughly, assessing its structure, fittings, and quality of construction. Investors look at the business’s ability to generate future cash flows, the strength of its balance sheet, the growth potential of its products, and its management quality. The most popular intrinsic valuation method is the Discounted Cash Flow (DCF) Analysis, where future cash flows are estimated and discounted to present value. This method attempts to answer, “How much is this business worth based purely on its own merit?”

Relative Valuation, on the other hand, compares a company with its peers or competitors. It’s like checking how other flats in the same neighbourhood are priced before deciding what you are willing to pay. Here, the company’s valuation is assessed using metrics like the Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, or EV/EBITDA multiple, relative to similar companies in the same sector. This approach tries to answer, “Is this business cheap or expensive compared to others like it?”

Example: Consider Infosys Limited. An intrinsic valuation would involve estimating its future cash flows based on its contracts, digital transformation projects, cost structure, and management capability. Meanwhile, a relative valuation would compare Infosys’s P/E ratio to that of TCS, Wipro, and HCL Tech to determine if Infosys is valued fairly against its peers.

Key Differences:

Note: Neither approach is perfect on its own. Intrinsic valuation can be highly sensitive to assumptions like growth rates and discount rates. Relative valuation depends on market conditions and may not always reflect a company's real quality.

Smart investors often use both approaches together. Intrinsic valuation tells you what the company is truly worth; relative valuation tells you how the market is pricing similar businesses. In the next chapter, we will dive deeper into the powerful Discounted Cash Flow (DCF) Analysis method — the gold standard for intrinsic valuation.