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relativevaluation - Equity Instruments Markets Part II...

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Aswath Damodaran 1 Equity Instruments & Markets: Part II B40.3331 Relative Valuation Aswath Damodaran
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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
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Aswath Damodaran 3 What is relative valuation? n In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. n To do relative valuation then, we need to identify comparable assets and obtain market values for these assets convert these market values into standardized values , since the absolute prices cannot be compared This process of standardizing creates price multiples. compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or over valued
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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 .... )
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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.
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Aswath Damodaran 6 Definitional Tests n Is the multiple consistently defined? Proposition 1: Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value.
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