Damodaran on Valuation

17.3. RELATIVE VALUATION

Most valuations in practice, including those of distressed firms, are relative valuations. In particular, firms are valued using multiples and groups of comparable firms. An open question then becomes whether the effects of distress are reflected in relative valuations and, if not, how best to do so.

17.3.1. Distress in Relative Valuation

It is not clear how distress is incorporated into an estimate of relative value. Consider how relative valuation is most often done. We choose a group of firms that we believe are comparable to the firm that we are valuing. Usually, we pick firms in the same business that our firm is in. We then standardize prices by computing a multiple— price to earnings, price to book, enterprise value to sales, or enterprise value to EBITDA. Finally, we examine how our firm measures up on this multiple relative to the comparable firms. Although this time-honored approach is used for distressed firms as well, two issues generally are unique to distressed firms:

1. Revenue and EBITDA multiples are used more often to value distressed firms than healthy firms. The reasons are pragmatic. Multiples such as price to earnings or price to book value often cannot even be computed for a distressed firm. Analysts therefore move up the income statement looking for a positive number. For firms that make heavy infrastructure investments, where depreciation and amortization are a significant charge against operating income and there are substantial ...