Damodaran on Valuation

Chapter 7. Relative Valuation: First Principles

In discounted cash flow valuation, the objective is to find the value of an asset, given its cash flow, growth, and risk characteristics. In relative valuation, the objective is to value an asset based on how similar assets are currently priced by the market. Consequently, there are two components to relative valuation. The first is that to value assets on a relative basis, prices have to be standardized, usually by converting prices into multiples of some common variable. While this common variable will vary across assets, it usually takes the form of earnings, book value, or revenues for publicly traded stocks. The second component is to find similar assets, which is challenging since no two assets are exactly alike. With real assets like antiques and baseball cards, the differences may be small and easily controlled for when pricing the assets. In the context of valuing equity in firms, the problems are compounded since firms in the same business can still differ on risk, growth potential, and cash flows. The question of how to control for these differences when comparing a multiple across several firms becomes a key one.

While relative valuation is easy to use and intuitive, it is also easy to misuse. In this chapter, we will develop a four-step process for doing relative valuation. In the process, we also develop a series of tests that can be used to ensure that multiples are correctly used.