1. Relative Valuation Advantages and Disadvantages
Now, let's discuss some advantages and disadvantages of relative valuation.
Advantages include simplicity, calculating and applying multiples is relatively
simple and a user friendly way of valuing a company.
Observable data; we can directly observe a public company's market capitalization,
the company's per share price times the number of shares outstanding.
In most circumstances, we can also observe the transaction or offer value
of an acquired target company, if the target was public, then we will
know the offer or transaction value, even if the target company is private,
the acquirer may still disclose the transaction value, if it's large enough.
Relative valuation also reflects current market conditions, much more so
than a DCF, and precedent transactions are useful for mergers and acquisitions
since it includes a control premium and reflects the market for certain
businesses. However, there are many disadvantages, while simplicity is an
advantage, relative valuation can be too simplistic, we are taking a company
which is made up of many, many different complex value drivers
and distilling that into what is essentially a single metric,
this makes it difficult to determine what actually drives a company's value.
Is it the return on capital? Is it growth prospects?
Additionally, no two companies or transactions are exactly alike,
this makes the valuation more difficult and subjective.
There are many different reasons multiples, companies, and transactions
may vary.
2. Let's practice!