The Technicalities of Relative Valuation
There are two types of valuation a) Relative valuation and b) intrinsic valuation.
For relative valuation, the value of the asset is based on how similar assets are priced (the value is calculated based on market multiple). In contrast, in intrinsic valuation the value of the assets is based on the cashflows, growth and risk (the value is calculated based on DCF).
Both methods are interconnected but might not give similar answers.
In this article we will look at steps for calculating the value of the assets through relative valuation.
Relative valuation is usually a three-step process:
Step1: Identify comparable assets and obtain market value for those assets.
Step 2: Convert the market value into standardized value as absolute price cannot be compared. For example, the property value of a 1-bedroom apartment will be different to a 3-bedroom apartment, so to standardize the value we calculate per sqm cost or per sqf cost to compare the prices. The process for standardization creates the market multiple.
To obtain the correct market multiple, the analyst should
define the multiple: Understanding of how the multiple is calculated
describe the multiple: Identify the cross-sectional distribution of the multiple
analyze the multiple: Understand the relationship between the multiple and each variable.
Step 3: Compare the standardized value or multiple for the assets being analysed to the standardized value of the comparable assets. The multiple can be adjusted based on the differences between the firms to judge that the assets is under or overvalued.
Why relative valuation is more attractive to an analyst:
It is far easier to sell the asset with relative valuation than intrinsic valuation because in relative valuation you need to find a comparable business and compare the valuation with the asset you are planning to sell to highlight that the asset that is to be sold, is cheaper than the market value.
It is easier to defend relative valuation than intrinsic valuation. The main reason is that in intrinsic valuation all the assumptions are explicit, and concerns can be easily raised. While in relative valuation all the assumptions used to reach the multiple are implicit.
Although, relative valuation is easier to use and usually provides the required results, the process of arriving at a business' value must include a detailed and comprehensive analysis that includes factors such as, past, present, and future earnings and overall prospects of the company.