Valuation: Getting to Know Relative Valuation

Using growth, risk and cash flows to identify bargains, correctly compare stocks with each other

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Oct 04, 2018
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Aswath Damodaran began chapter four of his book, "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," with this challenge:

“If Dell (DELL, Financial) is Trading at 17 Times Earnings, Apple (AAPL, Financial) has a PE ratio of 21, and Microsoft (MSFT, Financial) is priced at 11 times earnings, which stock offers the best deal? Is Dell cheaper than Apple? Is Microsoft a bargain compared to both Apple and Dell? Are they even similar companies?”

Chapter four, then, is about relative valuation, which is one of two primary types of valuation. The other, as covered in chapter three, was intrinsic valuation. And why is relative valuation important or helpful? Because it helps us identify bargains, the practice at the heart of value investing.

The author wrote there are “three essential steps” in relative valuation:

  1. Identify comparable assets with market prices (no assets such as private equity, unless within a different context).
  2. Find a common variable (such as price-earnings), across which the various assets can be compared, to produce standardized prices.
  3. Adjust for differences among the assets to ensure the values are standardized.

To illustrate further, Damodaran used the example of comparing houses: a ready-to-move-in, newer house will be priced higher than an older home that requires renovation.

Also worth noting: relative valuation can be done more quickly and easily than intrinsic valuation; it is also more likely to capture the current marked mood.

Getting back to standardized values, Damodaran offered three ways of establishing estimates:

  1. Market value of the equity: Based on the price per share or on the market cap (multiply shares outstanding by share price).
  2. Market value of the company: Sum the market value of both debt and equity (think return on capital).
  3. Market value of the operating assets, or alternatively, of the enterprise value: The same as market value of the company, but excluding its cash.

Next, the multiples, which may also be termed “valuation multiples,” refer to this process (not included in this book):

  • Identifying comparable assets.
  • Getting market values for them.
  • Converting the market values into standardized values, based a key indicator.

For example, you can get a standardized value such as price-earnings by dividing the market value of a stock by its net income. Or you could divide the enterprise value by EBITDA (earnings before interest, taxes, depreciation and amortization) to get a value that reflects the relationship between operating assets and operating cash flow.

Damodaran argued there are four keys to using multiples.

  • First, they must be consistently defined, and the first test of that is compare the numerator and the denominator. For example, if you use a numerator that is an equity, you must use an equity as the denominator as well. As a reminder to those, like me, who haven’t done advanced arithmetic for some time, the numerator is the number on top, the one that is “divided by”. The denominator is the number on the bottom, the one doing the “dividing”.
  • Second, there are descriptive tests. Without getting into detail, the key is to focus on a median, rather than an average. Again, as a refresher, an average is calculated by adding up all the numbers in a series and dividing them by the number of numbers (I hope that’s clear), while a median is the middle one in a series of numbers; there will be an equal number of numbers above and below the median. Getting back to the book, the difference between average and median is in how they handle outliers. And the bottom line, according to Damodaran, is that we should always use the median, not the average.
  • Third, analytical tests. Assumptions are vital in doing relative valuations, just as they are in intrinsic valuations. However, the author argues these assumptions are implicit and unstated in relative analyses, while those in discounted cash flow valuation are explicit and stated.
  • Fourth, we have application tests, which refers to minimizing differences among the companies being compared. To control for these differences, an analyst uses one (or more) of three approaches. One approach is comparing the multiple at which a company trades to the average for the sector. Another approach involves modifying the multiple to include the most important variable (price-earnins, for example). The third approach uses statistical techniques, including simple and multiple regressions.

Turning again to the broader comparison of intrinsic and relative valuations, Damodaran wrote they will likely yield different estimates, and may even reach the extent where one valuation shows a company is overvalued while the other shows the same company is undervalued.

He added that differences between the two come from divergent views about market efficiency. In the case of intrinsic (or discounted cash flow) valuations, there is an assumption that markets sometimes get the pricing wrong. Indeed, it assumes even complete sectors or the whole market can be priced incorrectly. It is also assumes these mistakes will be corrected over time.

When it comes to relative valuations, there is the assumption that while markets or individual stocks may be priced incorrectly, they are correct on average.

Damodaran finished chapter 4 with the following observations:

“In relative valuation, we estimate the value of an asset by looking at how similar assets are priced. While the allure of multiples remains their simplicity, the key to using them wisely remains finding comparable firms and adjusting for differences between the firms on growth, risk, and cash flows. Einstein was right about relativity, but even he would have had a difficult time applying relative valuation in today’s stock markets.”

The author: Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.

(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.