Fundamental Principles of Relative Valuation

CHAPTER 17 FUNDAMENTAL PRINCIPLES OF RELATIVE VALUATION In discounted cash flow valuation, the objective is to find the value of assets, given their cash flow, growth and risk characteristics. In relative valuation, the objective is to value assets, based upon how similar assets are currently priced in the market. While multiples are easy to use and intuitive, they are also easy to misuse. Consequently, a series of tests will be developed in this chapter that can be used to ensure that multiples are correctly used. 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 earnings, book values or sales. The second is to find similar firms, which is difficult to do since no two firms are identical and 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. Use of Relative Valuation The use of relative valuation is widespread. Most equity research reports and many acquisition valuations are based upon a multiple such as a price to sales ratio or the value to EBITDA multiple and a group of comparable firms. In fact, firms in the same business as the firm being valued are called comparable, though as you see later in this chapter, that is not always true. In this section, the reasons for the popularity of relative valuation are considered first, followed by some potential pitfalls.