value of equityin a firmwith a beta of 1.2, an expected
growthrateinearningspershareof 20 percent,andareturn
on equity of 40 percent,
4 we wouldfind otherfirmsacross theentire marketwith
similar characteristics.
5 Theotherisconsiderallfirmsinthemarketascomparable
firms and to control for differences on the fundamentals
across these firms using statistical techniques.
Controlling for Differences across Firms
Nomatterhowcarefullyweconstructourlistofcomparable
firms,wewillendupwithfirmsthataredifferentfromthe
firmwearevaluing.Thedifferencesmaybesmallonsome
variablesandlargeonothersandwewillhavetocontrolfor
thesedifferencesinarelativevaluation.Therearethreeways
ofcontrolling forthesedifferences:subjectiveadjustments,
modified multiples, and statistical techniques.
Subjective Adjustments
Relative valuation begins with two choices—the multiple
usedintheanalysisandthegroupoffirmsthatcomprisesthe
comparablefirms.Inmanyrelativevaluations,themultipleis
calculatedforeachofthecomparablefirmsandtheaverageis
computed. Toevaluate anindividualfirm,the analystthen
comparesthemultipleittradesattotheaveragecomputed;if
itissignificantlydifferent,theanalystcanmakeasubjective
judgmentaboutwhetherthefirm’sindividualcharacteristics
(growth, risk, or cash flows) may explain the difference.
Thus,afirmmayhaveaP/Eratioof 22 inasectorwherethe
averageP/Eisonly15,buttheanalystmayconcludethatthis
differencecanbejustifiedbecausethefirmhashighergrowth