CONCLUSION

In relative valuation, you estimate the value of an asset by looking at how similar assets are priced. To make this comparison, you begin by converting prices into multiples—standardizing prices—and then comparing these multiples across firms that you define as comparable. Prices can be standardized based on earnings, book value, revenue, or sector-specific variables.

While the allure of multiples remains their simplicity, there are four steps in using them soundly. First, you have to define the multiple consistently and measure it uniformly across the firms being compared. Second, you need to have a sense of how the multiple varies across firms in the market. In other words, you need to know what a high value, a low value, and a typical value are for the multiple in question. Third, you need to identify the fundamental variables that determine each multiple and how changes in these fundamentals affect the value of the multiple. Finally, you need to find truly comparable firms and adjust for differences between the firms on fundamental characteristics.