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Relative Valuation

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In discounted cash flow valuation, the objective is to find the value of assets, given

their cash flow, growth and risk characteristics. In relative valuation, the objective is to

value assets, based upon how similar assets are currently priced in the market. While

multiples are easy to use and intuitive, they are also easy to misuse. Consequently, a series

of tests were developed that can be used to ensure that multiples are correctly used.

There are two components to relative valuation. The first is that, to value assets on a

relative basis, prices have to be standardized, usually by converting prices into multiples of

earnings, book values or sales. The second is to find similar firms, which is difficult to do

since no two firms are identical and firms in the same business can still differ on risk,

growth potential and cash flows. The question of how to control for these differences,

when comparing a multiple across several firms, becomes a key one.

Use of Relative Valuation

The use of relative valuation is widespread. Most equity research reports and many

acquisition valuations are based upon a multiple such as a price to sales ratio or the Value to

EBITDA multiple and a group of comparable firms. In fact, firms in the same business as

the firm being valued are called comparable, though as you see later in this chapter, that is

not always true. In this section, the reasons for the popularity of relative valuation are

considered first, followed by some potential pitfalls.

Reasons for Popularity

Why is relative valuation so widely used? There are several reasons. First, a

valuation based upon a multiple and comparable firms can be completed with far fewer

assumptions and far more quickly than a discounted cash flow valuation. Second, a relative

valuation is simpler to understand and easier to present to clients and customers than a

discounted cash flow valuation. Finally, a relative valuation is much more likely to reflect

the current mood of the market, since it is an attempt to measure



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