Inrelativevaluation,wevalueanassetbasedonhowsimilar
assetsarepricedin themarket.Aprospective housebuyer
decideshowmuchtopayforahousebylookingattheprices
paidforsimilarhousesintheneighborhood.Abaseballcard
collectormakesajudgmentonhowmuchtopayforaMickey
Mantlerookiecardbycheckingtransactionpricesonother
MickeyMantle rookiecards. Inthesame vein,a potential
investorinastocktriestoestimateitsvaluebylookingatthe
market pricing of similar stocks.
Embeddedinthisdescriptionarethethreeessentialstepsin
relativevaluation.Thefirststepisfindingcomparableassets
that are priced by the market, a task that is easier to
accomplishwith real assetslike baseball cards and houses
than it is with stocks. All too often, analysts use other
companiesin thesamesectorascomparables,comparinga
software firm to other software firms or a utility to other
utilities, but we will question whether this practice really
yieldssimilarcompanieslaterinthischapter.Thesecondstep
isscalingthemarketpricestoacommonvariabletogenerate
standardizedpricesthatarecomparable.Whilethismaynot
be necessary when comparing identical assets (Mickey
Mantlerookiecards),itisnecessarywhencomparingassets
that vary in sizeorunits. Other things remaining equal,a
smallerhouseorapartmentshouldsellatalowerpricethana
larger residence.In thecontext ofstocks, this equalization
usuallyrequiresconvertingthemarketvalueofequityorthe
firmintomultiplesofearnings,bookvalue,orrevenues.The
thirdandlaststepintheprocessisadjustingfordifferences
across assets when comparing their standardized values.
Again, usingthe exampleofa house, a newer housewith
more updated amenities should be priced higher than a
similar-sizedolderhousethatneedsrenovation.Withstocks,