Relative Valuation
1. Relative Valuation
In this chapter, we discuss relative valuation. Relative valuation uses the valuation multiples of comparable firms to infer the value of the subject firm. Some common valuation multiples are price-to-earnings and price-to-book ratios.2. Law of One Price
Relative valuation is based on the what is known in economics as the Law of One Price. This means that if you have two assets that look the same, they must have the same price.3. Law of One Price (Example)
Let's look at an example to see how the Law of One Price works. Consider two stocks. Stock A has a price of $7. It pays $10 when the economy does well and $4 when the economy does poorly. Stock B has a price of $5, but it pays $8 when the economy does well and $2 when the economy does poorly. Now, suppose you are trying to value a firm that pays $9 when the economy does well and $3 when the economy does poorly. What is the price of the subject firm?4. The Subject Firm's Price is $6
The table on the slide shows the answer to problem we are currently facing. Notice though that the average payoff of Stock A and B is $9 when the economy does well and $3 when the economy does poorly. Those are the exact payoffs of our subject firm. So the price of the subject firm must then be equal to the average price of Stocks A and B or $6. This is essentially how relative valuation works. We look at stocks that look similar and take the average or median valuation of those comparable firms to infer the value of our subject firm.5. Identifying Comparables
A key to performing relative valuation is determining which firms are "comparable". This is more art than science, but we can use several common starting points. First, we can look at standard industry classifications and identify firms that are within the same industry classification as the subject firm. For example, in the exercise that would follow later, you will be asked to identify comparable firms in the pharmaceutical industry based on the Global Industry Classification Standard or GICS. One can also look at the firm's competitors, but this is a little tricky. Not all competitors are comparable. For example, Walmart may compete with the mom-and-pop store but no one would say that Walmart is "comparable" to the mom-and-pop store. When you get to an initial list, you have to look at the different fundamentals to make sure that the firms are indeed comparable. Depending on the metric used, we look at measures of risk, growth, and profitability.6. Let's practice!
In the exercise that follows, you will be given a data set of midcap companies, which are companies with a market capitalization between $2 and $10 billion. You will then be asked to extract firms within a certain GICS industry classification.Create Your Free Account
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