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Chapter 8. Relative Valuation > Reconciling Relative and Discounted Cash Flow V...

Reconciling Relative and Discounted Cash Flow Valuations

The two approaches to valuation—discounted cash flow valuation and relative valuation—will generally yield different estimates of value for the same firm. Furthermore, even within relative valuation, you can arrive at different estimates of value, depending on which multiple you use and on what firms you based the relative valuation.

The differences in value between discounted cash flow valuation and relative valuation come from different views of market efficiency or, put more precisely, market inefficiency. In discounted cash flow valuation, you assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, you assume that while markets make mistakes on individual stocks, they are correct on average. In other words, when you value Cisco relative to comparable companies, you are assuming that the market has priced these companies correctly, on average, even though it might have made mistakes in the pricing of each of them individually. Thus, a stock may be overvalued on a discounted cash flow basis but undervalued on a relative basis if the firms used in the relative valuation are all overpriced by the market. The reverse would occur if an entire sector or market are underpriced.


  

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