Equity Valuation and Portfolio Management

CHAPTER 4

Relative Valuation Methods for Equity Analysis

Glen A. Larsen Jr., Ph.D., CFA

Professor of FinanceIndiana University, Kelley School of Business—Indianapolis

Frank J. Fabozzi, Ph.D., CFA, CPA

Professor of FinanceEDHEC Business School

Chris Gowlland, CFA

Senior Quantitative AnalystDelaware Investments^*

Much research in corporate finance and similar academic disciplines is tilted toward the use of discounted cash flow (DCF) methods. However, many analysts also make use of relative valuation methods, which compare several firms by using multiples or ratios. Multiples that are commonly used for such purposes include price–earnings, price–book, and price–free cash flow.

Relative valuation methods implicitly assume that firms that are “similar” are likely to be receive “similar” valuations from investors. Therefore, on average, we would expect that firms that are generally comparable are likely to trade at similar multiples, in terms of price-to-earnings, price-to-book, or various other metrics. If this assumption is approximately correct, then relative valuation methods can be used to identify firms that look “cheap” or “expensive” relative to their peers. When a particular firm's multiples are extremely different from the rest of the universe, this may indicate a potential investment opportunity—though further analysis will likely be required to determine whether there are reasons why such a firm is valued differently from other companies which otherwise appear comparable. ...