Session 14: Relative Valuation - First Principles

Summary

This video discusses the two primary valuation methods: intrinsic and relative valuation. While intrinsic valuation focuses on an asset's cash flows, growth, and risk, relative valuation estimates worth based on comparable assets in the market. The speaker emphasizes that despite the theoretical preference for intrinsic valuation, most analysts rely on relative valuation due to its practicality and ease of use. Key steps for effective relative valuation include defining and analyzing multiples, identifying comparable assets, and controlling for differences. Ultimately, a strong understanding of both methods is essential for making informed investment decisions.

Takeaways

• 😀 Relative valuation involves assessing an asset's value based on similar assets' prices, rather than intrinsic cash flows and risks.
• 😀 In real estate, the price of a house is often determined by comparing it to recent sales of similar homes in the area.
• 😀 Most analysts prefer relative valuation due to its simplicity and ease of use compared to intrinsic valuation.
• 😀 Relative valuation is pervasive in financial analysis, as seen in the use of multiples like Price to Earnings (P/E) ratios.
• 😀 The majority of equity research reports (over 80%) utilize relative valuation methods rather than discounted cash flow models.
• 😀 When using relative valuation, it's essential to standardize prices (e.g., price per square foot for homes) for meaningful comparisons.
• 😀 Comparables in relative valuation must be carefully selected, as perceived similarities can lead to inaccurate conclusions.
• 😀 The assumptions underlying relative valuation are often implicit, making them harder to critique compared to the explicit assumptions in intrinsic valuation.
• 😀 Valuation is a selling process, and relative valuation can be more persuasive when selling assets, as it can make them appear cheaper than truly overvalued comparables.
• 😀 To effectively use relative valuation, analysts should follow a four-step process: define the multiple, describe the multiple, analyze the multiple, and then apply the multiple.

Q & A

What is relative valuation?

Relative valuation is a method of valuing an asset based on how similar assets are priced in the market, rather than its intrinsic cash flows, growth, and risk.

How do realtors typically determine the price of a house?

Realtors determine the price of a house by comparing it to similar houses in the neighborhood that have sold recently, rather than performing an intrinsic valuation.

What are the three key components of relative valuation?

The three key components of relative valuation are: a standardized price (often expressed as a multiple), a set of comparable assets, and a method for controlling differences across those assets.

Why do most analysts prefer relative valuation over intrinsic valuation?

Most analysts prefer relative valuation because it is easier to sell, defend, and provides a sense of security through commonality, as being wrong is less likely to result in negative consequences.

What is the difference between intrinsic and relative valuation?

Intrinsic valuation focuses on an asset's cash flows, growth, and risk, while relative valuation compares an asset's price to those of similar assets to determine its value.

What common metrics are used in relative valuation?

Common metrics in relative valuation include price-to-earnings (P/E) ratios, price-to-book ratios, and enterprise value multiples.

How should one define a multiple in relative valuation?

When defining a multiple, it is crucial to ensure that the numerator and denominator are consistent; for example, if using market value of equity in the numerator, the denominator must also reflect equity value.

What is the significance of analyzing the distribution of multiples?

Analyzing the distribution of multiples helps identify what is considered high, low, or typical, and allows analysts to make more informed comparisons between companies.

What does the author suggest regarding the assumptions embedded in multiples?

The author suggests that every multiple contains implicit assumptions about cash flows, growth, and risk, and these should be made explicit to avoid misleading comparisons.

What are the steps recommended for effectively using relative valuation?

The recommended steps for effective relative valuation include defining the multiple, describing its statistical properties, analyzing the variables that influence it, and then applying the multiple cautiously.