1. Relative Valuation
Now, let's talk about relative valuation. Under this methodology, the target
company's valuation is relative to other companies or transactions.
In other words, relative valuation compares the price of an asset,
business or investment to the market value of similar assets to determine
the value. An implicit assumption in relative valuation is that the other
firms or transactions are correctly priced by the market. In other words,
we assume the market is right on average, although some companies or transactions
may be individually mis priced. There are two types of relative valuations,
public company comparables, and precedent transactions. With public company
comparables, the valuation is based on the idea that similar public companies
share similar risk and reward characteristics and therefore should be valued
similarly. With precedent transactions, the valuation is based on the acquisition
of companies similar to the target company. One important thing to note,
precedent transactions usually result in higher multiples and valuations
due to the presence of the control premium, when a company is acquired.
These premiums can be up to 50% or more,
however, 20% to 30% is a fairly common rule of thumb.
Regardless of whether you're talking public company comparables or precedent
transactions, we calculate multiples, which are just ratios that scale companies
for differences in size of enterprise value or equity value.
Alternatively, we can see how a company's multiple has changed over time
and try to analyze the business reasons for doing so,
keep in mind that this could result in distorted multiples depending on
the time period that is analyzed. For example,
a company might look currently over valued if you compared its multiples
to what it was trading at during a recession.
2. Let's practice!