Equity Valuation and Portfolio Management

KEY POINTS

• Relative valuation methods tend to receive less attention from academics than DCF approaches, but such methods are widely used by practitioners. If relative valuation approaches suggest that a company is cheap on some metrics but expensive on others, this may indicate that the market views that company as being an outlier for some reason, and an analyst will probably want to investigate further.
• Choosing an appropriate group of comparable companies is perhaps the most challenging aspect of relative valuation analysis. Where possible, an analyst should seek to identify 6 to 12 companies that are similar in terms of risk characteristics, perhaps with attention to criteria such as size, geography, and industry. If this is not possible, then an analyst should feel free to relax one or more of these parameters in order to obtain a usable universe.
• Determining an appropriate set of valuation multiples is also important. Calculating a single set of multiples is likely to provide fewer insights than using several different metrics that span multiple time periods. It is conventional to use consensus estimates of future financial and operating performance, as these presumably represent the market's collective opinion of each firm's prospects.
• Most relative valuation analysis is performed using standard multiples such as price–earnings or firm value–sales. Under some conditions, using industry-specific multiples can be valuable, though there may be fewer consensus estimates for ...