Relative Valuation Reference Damodaran The Dark Side 1st ed

Relative Valuation Reference Damodaran The Dark Side 1st ed

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1 CHAPTER 8 RELATIVE VALUATION 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
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2 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 relative and not intrinsic value. Thus, in a market where all internet stocks see their prices bid up, relative valuation is likely to yield higher values for these stocks than discounted cash flow valuations. In fact, relative valuations will generally yield values that are closer to the market price than discounted cash flow valuations. This is particularly important for those whose job it is to make judgments on relative value, and who are themselves judged on a relative basis. Consider, for instance, managers of technology mutual funds. These managers will be judged based upon how their funds do relative to other technology funds. Consequently, they will be rewarded if they pick technology stocks that are under valued relative to other technology stocks, even if the entire sector is over valued.
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Relative Valuation Reference Damodaran The Dark Side 1st ed

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