Sanity Check
Sanity Check · Valuation Reality Check
A cross-check of whether a model's output makes sense against simple reference points — history, peers, common sense — before acting on it.
What it is
A sanity check is the final step after any calculation: does the result match reality, or is it an artifact of a bad input?
In valuation it typically means comparing:
- →The DCF result against relative valuation (P/E, EV/EBITDA) — are they in the same ballpark?
- →The current multiple against the company's historical average and against peers
- →The implied long-term growth or margin against what the company has ever actually achieved
A sanity check does not mechanically fix the model by nudging numbers to get a "nicer result" — its purpose is to reveal that an input assumption is unrealistic, so it can be consciously reconsidered.
Why track it
Models like DCF are sensitive to inputs (see terminal value) — a bad input (a unit typo, a currency misread, an unrealistic terminal growth rate) can produce a number an order of magnitude off reality without it being obvious at a glance. A sanity check is the safeguard that catches such errors before they become the basis for a decision.
Real-world example
The DCF comes out at $900/share for a company trading at $380, while P/E and EV/EBITDA are both in line with history and peers. The discrepancy signals that the DCF is probably built on an overly optimistic assumption (usually terminal growth or a persistently above-average margin) — not that the market is undervaluing the company by 140%.
Watch out for
A sanity check in itself does not determine whether the "correct" answer is DCF or relative valuation — it only flags the discrepancy. A low P/E does not necessarily mean undervaluation (it may be a value trap — slowing growth, deteriorating margins, a structural problem); a high P/E does not necessarily mean overvaluation (it may reflect genuinely above-average business quality).