Damodaran on Valuation

7.7. CONCLUSION

In relative valuation, we estimate the value of an asset by looking at how similar assets are priced. To make this comparison, we begin by converting prices into multiples—standardizing prices—and then comparing these multiples across firms that we 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, we have to define the multiple consistently and measure it uniformly across the firms being compared. Second, we need to have a sense of how the multiple varies across firms in the market. In other words, we need to know what a high value, a low value, and a typical value are for the multiple in question. Third, we need to identify the fundamental variables that determine each multiple and how changes in these fundamentals affect the value of the multiple. Finally, we need to find truly comparable firms and adjust for differences among the firms on fundamental characteristics.