Essay About Relative Valuation And Cash Flow Valuation

Relative Valuation
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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 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