The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

RELATIVE VALUATION METHODS

Although stock and company valuation is very strongly tilted toward the use of DCF methods, it is impossible to ignore the fact that many analysts use other methods to value equity and entire companies. The primary alternative valuation method is the use of multiples (that is, ratios) that have price or value as the numerator and some form of earnings or cash flow generating performance measure for the denominator and that are observable for other similar or like-kind companies.

These multiples are sometimes called “price/X ratios,” where the denominator “X” is the appropriate cash flow generating performance measure and the numerator is either a market value per share or a total market value. For example, the price/earnings (P/E) ratio is a popular multiple used for relative valuation, where an earnings estimate is the cash flow generating performance measure. Keep in mind that the terms relative valuation and valuation by multiples are used interchangeably here as are the terms price and value.

The essence of valuation by multiples assumes that similar or comparable companies are fairly valued in the market. As a result, the scaled price or value (the present value of expected future cash flows) of similar companies should be much the same. That is, comparable companies should have similar price/X ratios. The key for the analyst is to find the comparable companies that can be used for valuing a target company using valuation by multiples.

Valuation ...