Relative Valuation Models

Relative Valuation Models

In discounted cash flow valuation, the objective is to find the value of an asset, given its cash flow, growth and risk characteristics. In relative valuation, the objective is to value an asset, based upon how similar assets are currently priced by the market. Consequently, there are two components to relative valuation. The first is that to value assets on a relative basis, prices have to be standardized, usually by converting prices into multiples of some common variable. While this common variable will vary across assets, it usually takes the form of earnings, book value or revenues for publicly traded stocks.

The second is to find similar assets, which is difficult to do since no two assets are exactly identical. With real assets like antiques and baseball cards, the differences may be small and easily controlled for when pricing the assets. In the context of valuing equity in firms, the problems are compounded since firms in the same business can still differ on risk, growth potential and cash flows. The question of how to control for these differences, when comparing a multiple across several firms, becomes a key one. While relative valuation is easy to use and intuitive, it is also easy to misuse. In this chapter, we will develop a four-step process for doing relative valuation. In the process, we will also develop a series of tests that can be used to ensure that multiples are correctly used.

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