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Valuation Concepts and Methods - Topic 4

BS in Accountancy (Cor Jesu College)

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VALUATION CONCEPTS AND METHODS

MODULE 4 – RELATIVE VALUATION

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RELATIVE VALUATION
INTENDED LEARNING OUTCOMES:

✓ Def nition and description of Relative Valuation

✓ Steps in Relative Valuation
✓ Market Value
✓ Market Multiples
✓ Wide application of Relative Valuation
✓ Advantages and Limitations of Relative Valuation
✓ When to use Relative Valuation

ACTIVITY

“The price attainable in an arm’s length sale between a willing seller and a willing prudent buyer in the
open market” - KPMG LLP

RELATIVE VALUATION
ANALYSIS

What is Relative Valuation?

This approach is based on the premise that the value of any asset can be estimated by analysing how
the market prices ‘similar’ or ‘comparable’ assets. The basic belief here is that it is impossible or
extremely difficult to estimate the intrinsic value of an asset, and therefore, the value of an asset is
whatever the market is willing to pay for it.

Most valuations in the Stock Market are relative valuations.

The following data relating to the US Stock Market are quite revealing:

a) Almost 85% of equity research reports are based upon a multiple and comparables.
b) More than 50% of all acquisition valuations are based upon multiples.
c) Rules of thumb based on multiples are not only common but are often the basis for final
valuation judgments.

Steps in Relative Valuation:

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The following steps have to be followed in carrying out relative valuation:

1. Identify comparable assets and obtain market values for these assets.
2. Convert these market values into standardized values, since the absolute prices cannot be
compared. This process of standardizing creates price multiples.
3. Compare the standardized value or multiple for the asset being analyzed with the standardized
values for comparable asset, adjusting for any differences between the firms that might affect
the multiple, to judge whether the asset is under or overvalued.

The most commonly used multiples are:

a) Revenue or sales multiples

b) EBITDA multiples
c) Operational multiples
d) Operating free cash flow multiples
e) Earnings multiples
f) Book value multiples

Market Value:

The starting point for determining market multiples is the market values of companies whose shares are
listed and hence quoted on a stock exchange. Publicly listed companies, those with shares listed on
stock exchanges, have their share prices quoted by market makers whose job it is to provide a market in
shares. This gives an instant picture of a company’s value. The market value of a company may be
derived from multiplying the share price by the number of shares in issue.

For large companies traded on the major stock exchanges, the share price will represent a price at which
the shares were very recently traded and so will give an up-to-date valuation. For less liquid shares, in
closely held companies or traded on emerging stock markets, the price may be somewhat out of date or
may not be realistic for a larger than average trade. Such less liquid stocks will have wider spreads
between the bid and ask prices to reflect their lack of liquidity – it will be more difficult for a market
maker to sell on or buy back the trade the maker has completed.

In this context, it will be pertinent to keep in mind the following note of warning issued by the Stock
Markets:

“We desire to state authoritatively that Stock Exchange quotations are not related directly to the value
of a company’s assets, or to the amount of its profits, and consequently these quotations, no matter
what date may be chosen for references, cannot form a fair and equitable basis for compensation.

The Stock Exchange may be likened to a scientific recording instrument which registers, not its own
actions and opinions, but the actions and opinions of private and institutional investors all over the
country and, indeed, the world. These actions and opinions are the result of hope, fear, guesswork,
intelligence or otherwise, good or bad investment policy, and many other considerations. The quotations
that result definitely do not represent a valuation of a company by reference to its asset and earning
potential”.

Market Multiples:

The following Table gives a listing of a number of ratios that can be applied to companies for which a
share price and market value are not available, with some of their major pros and cons.

For instance, where a company’s shares are not quoted, the potential buyer or seller may be prepared
to pay a multiple of the company’s assets, profits or cash flow, where the multiple is based on multiples
derived from companies for which there is a share price and market value. It should be noted that these
multiples can be applied at the share level or company level, depending on whether an investor is
looking at the purchase or sale of a few shares, or the whole company as a potential acquirer.

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Wide application of Relative Valuation:

While it is true that in practice DCF valuations appear to be more widely used in business valuations, it is
widely opined that they are often relative valuations masquerading as DCF valuations. This carries some
conviction as the objective in many DCF valuations is to reach a number that has been obtained by using
a multiple, and the terminal value in a large number of DCF valuations is estimated using a multiple.

Therefore, Relative valuation is a lot more likely to reflect market perceptions than DCF valuation. It can
thus be an advantage when it is important that the price reflects these perceptions as is the case when
the objective is to sell a security at that price today as in the case of an IPO.

The following inferences can therefore be drawn with regard to relative valuation:

a) There will always be a significant proportion of securities that are under-and over-valued.
b) Relative valuation is more suited to the needs of portfolio managers, as they are most often
judged based upon how they perform on a comparable or relative basis to the market and other
fund/money managers.
c) Relative valuation generally requires less information than DCF valuation.
d) Even if DCF valuation is carried out, presenting the findings on a relative valuation basis will
make the findings/recommendations more easily acceptable to a larger audience.
e) In some cases, relative valuation can help in identifying weak spots in DCF valuations.
f) The problem with multiples is not in their use but in their abuse. If they can be worked out
correctly, then relative valuation can be quite useful.

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Advantages of Relative Valuation:

a. As already mentioned, Relative valuation is much more likely to reflect market perceptions and
moods than DCF valuation.
b. Relative valuation generally requires less information than DCF valuation.

Disadvantages of Relative Valuation:

Relative valuation may require less information in the way in which most analysts and portfolio
managers use it. However, this is because implicit assumptions are made about other variables that
would have been required in a DCF valuation. To the extent that these implicit assumptions are wrong
the relative valuation will also be wrong.

When to use Relative Valuation?

Relative Valuation is easy to use under the following circumstances:

a) There are a large number of assets comparable to the one being valued.
b) These assets are priced in a market.
c) There exists some common variable that can be used to standardize the price.

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APPLICATION

(See Attached Assessment)

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