We can use four basic multiples when using relative valuation, with many variations on those themes. Because the prices of Mastercard and Visa aren’t comparable, we need to use standardized multiples to compare the companies. Let’s think about the price of a stock for a moment that price remains a function of the value of the equity and the number of shares outstanding in a firm. Multiples are useful with many comparable companies, but they tend towards more difficulty with unique firms that don’t have a lot of comparables in their industry or businesses with little or no revenue or negative earnings.īefore we dive in and discuss using relative valuation to value a company, let’s briefly explore the standardization of value and multiples. The allure of multiples is that they remain simple and easy for all investors to relate to them. Unlike a discounted cash flow, relative valuation requires our faith in the market is right much more than searching for intrinsic value. We have many different examples of these examples, and the list of metrics or multiples used in relative valuation remains too great to list them all. We can base all of it on the belief that the market continues correctly pricing those other companies, thus making the comparison correct.Īnother example is the use of price to book, with companies selling at a discount to book value compared to other companies being considered undervalued. The assumption remains that the other companies in the industry remain comparable to the firm we analyze. We can use an average industry price-to-earnings ratio to value firms. Using relative valuation, we find the value of an asset deriving from the price of comparable assets, which we standardize using a common variable such as revenues, earnings, cash flows, or book value. The value of most assets, from the house or car we buy to the stocks we invest in, is based on how closely they align with similar market assets.
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