The Implications for Valuation

When valuing a firm, you draw on information from three sources. The first is the current financial statements for the firm. You use these statements to determine how profitable a firm's investments are or have been, how much it reinvests to generate future growth, and for all of the inputs that are required in any valuation. The second is the past history of the firm, both in terms of earnings and market prices. A firm's earnings and revenue history over time let you make judgments on how cyclical a firm's business has been and how much growth it has shown, and the firm's price history can help you measure its risk. Finally, you can look at the firm's competitors or peer group to gauge how much better or worse a firm is than its competition and also to estimate key inputs on risk, growth, and cash flows.

While you would optimally like to have substantial information from all three sources, you may often have to substitute more of one type of information for less of the other if you have no choice. For example, the 75 years or more of history on each of the large automakers in the United States compensate for the fact that there are only three of these automakers.^[6] In contrast, there may be only 5 years of information on Abercombie and Fitch, but the firm is in a sector (specialty retailing) where there are more than 200 comparable firms. The ease with which you can obtain industry averages and the precision of these averages compensate for the lack of history at the firm.