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Essay / The basic concept behind relative valuation
The basic concept behind relative valuation or multiples is that identical assets should sell at identical prices (Koller et al., 2015). This method is considered easy to understand, apply and communicate. However, multiples are often misapplied. According to Damadoran (2012) and Goedhart et al. (2005), relative valuation has major shortcomings. First, market trading levels may depend on periods of irrational investor sentiment that will skew the company's valuation either too high or too low relative to similar companies. Second, this method can be easily manipulated. Different assumptions in the choice of multiple measures or peer groups may lead to distinct conclusions. However, Fernández (2001) and Goedhart et al. (2005) agree that multiples provide useful information for testing the DCF model and insights into the dynamics of the industry and its players. Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”? Get the original essay Fernández (2001) divides multiples into three categories. The first is based on the company's market capitalization and includes price-to-earnings (P/E), price-to-book equity (P/BV), and price-to-sales (P/S) ratios. Although widely used, Goedhart et al. (2005) identify two major flaws in the use of P/E multiples: they are constantly affected by capital structure and are impacted by non-operational elements, such as one-off events. The second category is based on enterprise value (EV). The most common include EV-to-EBITDA, EV-to-EBIT and EV-to-Revenue. Finally, price/earnings growth or EV/EBITDA growth multiples are included in the last category, hinting at growth. These ratios are then multiplied by the company's performance figures to estimate its stock price. Additionally, Goedhart et al. (2005) present four principles for correctly valuing a company using multiples. First, the authors emphasize the importance of choosing peers with similar ROIC and growth expectations. Second, they argue that the EV/EBITA ratio is superior to other ratios since it is not affected by capital structure, unless significant changes in the cost of capital occur, thus providing "a more accurate comparison comparable” between company values. (Koller et al., 2015). Third, they suggest adjusting this ratio for non-operating items such as excess cash, operating leases, employee stock options and pensions. Finally, they advise the use of forward-looking multiples based on “forecasted rather than historical earnings.” Choosing the right reference group is crucial for reasonable relative valuation. The relevant comparable companies must have similar business models and operations. Additionally, these companies must be competitive in the same markets, be exposed to the same macroeconomic environment, and have similar growth and capital return prospects (Foushee et al., 2012). Consistent with Fernández (2001), the flexibility to delay an investment has value in itself and the real options approach attempts to capture it, whereas other methods such as net present value and internal rate of return do not succeed. Failure to take this flexibility into account leads to undervaluation of lucrative projects (Fernández, 2001, and Michaels and Leslie, 1997). Fernández (2001) classifies..