RELATIVE VALUATION

While we tend to focus most on discounted cash flow valuation when discussing valuation, the reality is that most valuations are relative valuations. The values of most assets, from the house you buy to the stocks you invest in, are based on how similar assets are priced in the marketplace. This section begins with a basis for relative valuation, moves on to consider the underpinnings of the model, and then considers common variants within relative valuation.

Basis for Relative Valuation

In relative valuation, the value of an asset is derived from the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues. One illustration of this approach is the use of an industry-average price-earnings ratio to value a firm, the assumption being that the other firms in the industry are comparable to the firm being valued and that the market, on average, prices these firms correctly. Another multiple in wide use is the price–book value ratio, with firms selling at a discount on book value relative to comparable firms being considered undervalued. Revenue multiple are also used to value firms, with the average price-sales ratios of firms with similar characteristics being us....