Relative Valuation is Valuing an asset by comparing with prices of similar assets in market. In relative valuation the value is relative to how the market is pricing comparable firms
There are three basic steps
–Identify comparable assets
–Standardize – price of the asset or the value of equity
–Adjust for differences
Why popularity of Relative Valuation in analyst circle?
•It is Easy to sell a story based on comparables
–Pebble beach golf – Japanese paid 750$ mn in late 1980’s
–At that time All of Tokyo real was estimated to be cost more than all of US real estate put together
–Business potential did not justify the price
–Imagine selling a DCF based valuation!!!
•Most Assumptions and inaccuracies are hidden
•If you mess up so would have others
–You don’t want to be wrong all alone on the street
Is there widespread use ?? Of course …
•Majority of research reports are based on Relative Valuation
•Mergers and Acquisitions derive valuations based on a multiple based prices of comparable firms.
•Many investment strategies are based on multiple (eg: Venture Capital/PE fund investing in entrepreneurial ventures)
•Terminal Value in DCF often calculated using Relative Valuation
•DCF used to justify Relative Valuation quite often
More on Common Multiples later….