differencesinpricingacrossstockscanbeattributedtoallof
thefundamentalsthatwetalkedaboutindiscountedcashflow
valuation. Higher-growth companies, for instance, should
tradeathighermultiplesthanlower-growthcompaniesinthe
same sector. Many analysts adjust for these differences
qualitatively, makingeveryrelative valuationa storytelling
experience;analystswithbetterandmorebelievablestories
are given credit for better valuations.
AswenotedinChapter1,thereisasignificantphilosophical
difference between discounted cash flow and relative
valuation. In discounted cash flow valuation, we are
attemptingtoestimatetheintrinsicvalueofanassetbasedon
itscapacitytogeneratecashflowsin thefuture.Inrelative
valuation,wearemakingajudgmentonhowmuchanassetis
worthby lookingatwhat themarket is payingforsimilar
assets.Ifthemarketiscorrectonaverageinthewayitprices
assets, discountedcash flowand relative valuations should
converge. If, however, the market is systematically
overpricing or underpricing a group of assets or an entire
sector, discounted cash flow valuations can deviate from
relative valuations.
UBIQUITY OF RELATIVE VALUATION
Notwithstandingthefocusondiscountedcashflowvaluation
inclassroomsandintheory,thereisevidencethatmostassets
are valued on a relative basis. In fact, consider the following:
- Mostequityresearchreportsarebasedonmultiples:
price-earnings ratios, enterprise value-to-EBITDA
ratios, and price-to-sales ratios are but a few
examples.Inaninformalstudyof 550 equityresearch