softwarecompanyrelativetoothersmallsoftwarecompanies,
weareassumingthatthemarkethaspricedthesecompanies
correctly on average, even though it might have made
mistakesinthepricingofeachofthemindividually.Thus,a
stockmaybeovervaluedonadiscountedcashflowbasisbut
undervalued on a relative basis, if the firms used for
comparisonintherelativevaluationarealloverpricedbythe
market.Thereversewouldoccurifanentiresectorormarket
were underpriced.
CONCLUSION
Inrelative valuation,weestimate thevalueof an asset by
looking at how similar assets are priced. To make this
comparison, we begin by converting prices into
multiples—standardizing prices—and then comparing these
multiplesacrossfirms thatwedefineascomparable.Prices
canbestandardizedbasedonearnings,bookvalue,revenue,
or sector-specific variables.
Whiletheallureofmultiplesremainstheirsimplicity,there
arefourstepsinusingthemsoundly.First,wehavetodefine
themultipleconsistentlyandmeasureituniformlyacrossthe
firmsbeingcompared.Second,weneedtohavea senseof
howthemultiplevariesacrossfirmsinthemarket.Inother
words,weneedtoknowwhatahighvalue,alowvalue,anda
typicalvalueareforthemultipleinquestion.Third,weneed
to identify the fundamental variables that determine each
multipleand howchangesinthesefundamentalsaffect the
value of the multiple. Finally, we need to find truly
comparablefirmsandadjustfordifferencesamongthefirms
on fundamental characteristics.