reports in early 2001, relative valuations
outnumbered discounted valuations almost 10 to 1.
1 While manyequity researchreports included the
obligatory cash flow tables, valueswere estimated
and recommendations were made by looking at
comparable firms and usingmultiples. Thus, when
analystscontendthatastockisunder-orovervalued,
theyare usuallymaking thatjudgment based ona
relative valuation.- Discountedcash flowtechniques aremorecommon
in acquisitions andcorporate finance. While casual
empiricismsuggeststhatalmosteveryacquisitionis
backedupbya discountedcash flowvaluation,the
value paid in the acquisition is often determined
using a multiple. In acquisition valuation, many
discounted cash flow valuations are themselves
relativevaluations in disguise becausethe terminal
values are computed using multiples. - Most investment rules of thumb are based on
multiples. For instance, many investors consider
companiesthattradeatlessthanbookvalueascheap
aswellasstocksthattradeatP/Eratiosthatareless
than the expected growth rates.
Given that relativevaluationis sodominant in practice, it
would be a mistake to dismiss it as a tool of the
unsophisticated.Aswewillargueinthischapterandthenext
two,relativevaluationhasaroletoplaythatisseparateand
different from discounted cash flow valuation.
REASONS FOR POPULARITY AND POTENTIAL
PITFALLS