an intrinsic valuation. Extending this analogy to stocks,
investorsoftendecidewhetherastockischeaporexpensive
bycomparingitspricingtothatofsimilarstocks(usuallyin
its peer group). In this section, we consider thebasis for
relative valuation, ways in which it can be used, and its
advantages and disadvantages.
Basis for Approach
Inrelativevaluation,thevalueofanassetisderivedfromthe
pricingofcomparableassets,standardizedusinga common
variable.Includedinthisdescriptionaretwokeycomponents
ofrelativevaluation.Thefirstisthenotionofcomparableor
similarassets.Fromavaluationstandpoint,thiswouldimply
assetswithsimilarcashflows,risk,andgrowthpotential.In
practice,itisusuallytakentomeanothercompaniesthatare
inthesamebusinessasthecompanybeingvalued.Theother
is a standardizedprice. After all, theprice per share of a
companyisinsomesensearbitrarysinceitisafunctionofthe
numberofsharesoutstanding;atwo-for-onestocksplitwould
halvetheprice.Dividingthepriceormarketvaluebysome
measurethatisrelatedtothatvaluewillyieldastandardized
price. When valuing stocks, this essentiallytranslates into
using multiples where we divide the market value by
earnings,bookvalue,orrevenuestoarriveatanestimateof
standardized value. We can then compare these numbers
across companies.
The simplest and most direct applications of relative
valuationsarewithrealassetswhereitiseasytofindsimilar
assetsorevenidenticalones.TheaskingpriceforaMickey
Mantlebaseball cardora 1965 FordMustang isrelatively
easy to estimategiven thatthere areotherMickey Mantle