In relative valuation, we value an asset based upon how similar assets are priced in the market. A prospective house buyer decides how much to pay for a house by looking at the prices paid for similar houses in the neighborhood. A baseball card collector makes a judgment on how much to pay for a Mickey Mantle rookie card by checking transactions prices on other Mickey Mantle rookie cards. In the same vein, a potential investor in a stock tries to estimate its value by looking at the market pricing of “similar” stocks.
39.1 STEPS IN RELATIVE VALUATION
Embedded in this description are the three essential steps in relative valuation. The first step is finding comparable assets that are priced by the market, a task that is easier to accomplish with real assets like baseball cards and houses than it is with stocks. All too often, analysts use other companies in the same sector as comparable, comparing a software firm to other software firms or a utility to other utilities, but we will question whether this practice really yields similar companies later in this part. The second step is scaling the market prices to a common variable to generate standardized prices that are comparable. While this may not be necessary when comparing identical assets (Mickey Mantle rookie cards), it is necessary when comparing assets that vary in size or units. Other things remaining equal, a smaller house or apartment should trade at a lower price than a larger residence. In the context ...