Damodaran on Valuation

7.4. STANDARDIZED VALUES AND MULTIPLES

When comparing identical assets, we can compare the prices of these assets. Thus, the price of a Tiffany lamp can be compared to the price at which an identical item was bought or sold in the market. However, comparing assets that are not exactly similar can be a challenge. If we have to compare the prices of two buildings of different sizes in the same location, the smaller building with its lower price will look cheaper unless we control for the size difference by computing the price per square foot. Things get even messier when comparing publicly traded stocks across companies. After all, the price per share of a stock is a function both of the value of the equity in a company and the number of shares outstanding in the firm. Thus, a stock split that doubles the number of units will approximately halve the stock price. To compare the values of similar firms in the market, we need to standardize the values in some way by scaling them to a common variable. In general, values can be standardized relative to the earnings firms generate, to the book value or replacement cost of the firms themselves, to the revenues that firms generate, or to measures that are specific to firms in a sector.

7.4.1. Earnings Multiples

One of the more intuitive ways to think of the value of any asset is as a multiple of the earnings that asset generates. When buying a stock, it is common to look at the price paid as a multiple of the earnings per share (EPS) generated ...