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Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition by Aswath Damodaran

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CHAPTER 17

Fundamental Principles of Relative Valuation

In discounted cash flow valuation, the objective is to find the value of assets, given their cash flow, growth, and risk characteristics. In relative valuation, the objective is to value assets based on how similar assets are currently priced in the market. While multiples are easy to use and intuitive, they are also easy to misuse. Consequently, a series of tests are developed in this chapter that can be used to check that multiples are correctly used.

There are two components to relative valuation. The first is that, to value assets on a relative basis, prices have to be standardized, usually by converting prices into multiples of earnings, book values, or sales. The second is to find similar firms, which is difficult to do since no two firms are identical and firms in the same business can still differ on risk, growth potential, and cash flows. The question of how to control for these differences, when comparing pricing across several firms, becomes a key one.

USE OF RELATIVE VALUATION

The use of relative valuation is widespread. Most equity research reports and many acquisition valuations are based on a comparison of a company to comparable firms, using a multiple such as PE as the basis. In fact, firms in the same business as the firm being valued are called comparable, though, as you will see later in this chapter, that is not always true. In this section, the reasons for the popularity of relative valuation are considered ...

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