Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 30. Applied Equity Valuation: Relative Valuation Method

GLEN A. LARSEN JR., PhD, CFA

Professor of Finance, Indiana University, Kelley School of Business–Indianapolis

Abstract: The primary alternative valuation method is relative valuation. Relative valuation involves the use of multiples (ratios) that have "price" as the numerator and a "cash flow–generating performance measure" for the denominator and that are observable for other "similar" or like-kind firms. In using relative valuation, we assume that we can find comparable firms that are in the same risk class as the firm we are attempting to value and that the observable market clearing price for the comparable firms is a fair price. As with the discounted cash flow method, the relative valuation method requires strong assumptions and expectations about the future. No one single valuation model or method is perfect. All valuation estimates are subject to model error and estimation error.

Keywords: relative valuation, fair market price, intrinsic value, dividend discount model, valuation by multiples, estimation error, model error

Although stock and firm valuation is very strongly tilted toward the use of discounted cash flow (DCF) methods, it is impossible to ignore the fact that many analysts use other methods to value equity and entire firms. The primary alternative valuation method is the use of multiples (ratios) that have "price" as the numerator and a "cash flow–generating performance measure" for the denominator ...