CHAPTER 7
Relative Valuation: First Principles
Indiscountedcashflowvaluation,theobjectiveistofindthe
value of an asset, given its cash flow, growth, and risk
characteristics.Inrelativevaluation,theobjectiveistovalue
anassetbasedonhowsimilarassetsarecurrentlypricedby
the market. Consequently, there are two components to
relativevaluation.Thefirstisthattovalueassetsonarelative
basis,priceshavetobestandardized,usuallybyconverting
pricesintomultiplesofsome commonvariable.Whilethis
commonvariablewillvaryacrossassets,itusuallytakesthe
formofearnings,bookvalue,orrevenuesforpubliclytraded
stocks.Thesecondcomponentistofindsimilarassets,which
ischallengingsincenotwoassetsareexactlyalike.Withreal
assetslikeantiquesandbaseballcards,thedifferencesmaybe
smallandeasilycontrolledforwhenpricingtheassets.Inthe
context of valuing equity in firms, the problems are
compoundedsincefirmsinthesamebusinesscanstilldiffer
on risk,growth potential,and cash flows.Thequestion of
how to control for these differences when comparing a
multiple across several firms becomes a key one.
Whilerelativevaluationiseasytouseandintuitive,itisalso
easytomisuse.Inthischapter,wewilldevelopafour-step
processfordoingrelativevaluation.Intheprocess,wealso
develop a series of tests that can be used to ensure that
multiples are correctly used.
WHAT IS RELATIVE VALUATION?