Aswath Damodaran 1 Equity Instruments & Markets: Part II B40.3331 Relative Valuation Aswath Damodaran
Aswath Damodaran 2 Why relative valuation? “If you think I’m crazy, you should see the guy who lives across the hall” Jerry Seinfeld talking about Kramer in a Seinfeld episode “ A little inaccuracy sometimes saves tons of explanation” H.H. Munro
Aswath Damodaran 3 What is relative valuation? •comparethe standardized value or multiple for the asset being analyzed tothe standardized values for comparable asset, controlling for anydifferences between the firms that might affect the multiple, to judgewhether the asset is under or over valued
Aswath Damodaran 4 Standardizing Value n Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues. • Earnings Multiples – Price/Earnings Ratio (PE) and variants (PEG and Relative PE) – Value/EBIT – Value/EBITDA – Value/Cash Flow • Book Value Multiples – Price/Book Value(of Equity) (PBV) – Value/ Book Value of Assets – Value/Replacement Cost (Tobin’s Q) • Revenues – Price/Sales per Share (PS) – Value/Sales • Industry Specific Variable (Price/kwh, Price per ton of steel .... )
Aswath Damodaran 5 The Four Steps to Understanding Multiples n Define the multiple • In use, the same multiple can be defined in different ways by different users. When comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated n Describe the multiple • Too many people who use a multiple have no idea what its cross sectional distribution is. If you do not know what the cross sectional distribution of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low. n Analyze the multiple • It is critical that we understand the fundamentals that drive each multiple, and the nature of the relationship between the multiple and each variable. n Apply the multiple • Defining the comparable universe and controlling for differences is far more difficult in practice than it is in theory.
Aswath Damodaran 6 Definitional Tests n
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