keyroleintheriseofearningsmultiplesthroughthe1990s.
Someofthechange,though,comesfromchangesinmarket
perception of risk.As investors become more risk averse,
whichtendstohappenduringrecessions,multiplespaidfor
stocks will decrease.
Fromapracticalstandpoint,whataretheconsequences?The
firstisthatcomparisonsofmultiplesacrosstimearefraught
withdanger.Inthenextchapter,forinstance,weconsiderthe
common practice of branding a market to be under- or
overvalued based on comparing the P/E ratio today to
historicalP/E ratios.The second isthat relativevaluations
haveshort shelflives.A stockmay lookcheap relativeto
comparablecompanies today,but thatassessment canshift
dramaticallyover thenextfewmonths. Intrinsicvaluations
are inherently more stable than relative valuations.
Analytical Tests
Indiscussingwhyanalystsweresofondofusingmultiples,
wearguedthatrelativevaluationsrequirefewerassumptions
than discounted cash flow valuations. While this is
technicallytrue,itis soonly onthesurface.Inreality,we
make just as many assumptions when we do a relative
valuationaswedoinadiscountedcashflowvaluation.The
differenceisthattheassumptionsinarelativevaluationare
implicitandunstated,whereasthoseindiscountedcashflow
valuationareexplicitandstated.Thetwoprimaryquestions
thatweneedtoanswerbeforeusingamultipleare:Whatare
the fundamentals that determine at what multiple a firm
shouldtrade?Howdochangesinthefundamentalsaffectthe
multiple?