Session 14: Relative Valuation - First Principles

Introduction to Relative Valuation

In this section, the speaker introduces relative valuation and explains how it differs from intrinsic valuation. He also discusses the prevalence of relative valuation in the industry.

What is Relative Valuation?

• Relative valuation involves valuing an asset based on how similar assets are priced.

• It differs from intrinsic valuation, which values an asset based on its cash flows, growth, and risk.

• The standardized price takes the form of a multiple, while comparable assets are usually called comparable firms.

• Differences between assets must be controlled for in order to accurately use relative valuation.

Prevalence of Relative Valuation

• Most equity research reports use relative valuation rather than discounted cash flow evaluations.

• Even in corporate finance, half of acquisition valuations use discounted cash flow evaluations with most using multiples for terminal value estimation.

• Despite this prevalence, many analysts do not use relative valuation correctly.

Conclusion

The speaker concludes by discussing his own biases towards intrinsic valuation and asking students which approach they prefer.

Preferred Approach

• When asked to choose their preferred approach after learning multiple methods, 70% of students chose discounted cash flow or intrinsic valuation.

• About 20% chose relative valuation and 10% were unsure.

Why Relative Valuation is Attractive to Analysts

In this section, the speaker explains why relative valuation is attractive to analysts and provides three possible answers.

Three Possible Answers

• The first reason relative valuation is attractive to analysts is that it's easier to sell a product with a relative valuation than an intrinsic one. By finding something more overvalued than what they're selling, they can make their product seem cheap.

• The second reason is that it's easier to defend a relative valuation because all assumptions are implicit. This makes it difficult for others to pick apart the assumptions being made.

• The third reason is that in the long term, intrinsic valuations are more likely to be correct. However, if you're wrong with an intrinsic valuation, you're more likely to be wrong alone and potentially fired. With relative valuations, there's always company when you're wrong.

Using Relative Valuation in Your Toolkit

In this section, the speaker discusses how we can bring relative valuation into our toolkits and outlines four basic propositions or ways in which we can prevent ourselves from making mistakes with relative valuation.

Multiples

• To make comparisons across companies, we need to use multiples. Every multiple has a numerator and denominator. In the numerator, we almost always need a measure of market value such as market cap or enterprise value. In the denominator, we can see measures such as revenues or earnings per share.

Four Steps for Relative Valuation

1. Define the multiple by describing it using stat 101 methods.

2. Find comparable companies and calculate their multiples.

3. Compare the multiples of the company you're analyzing to those of its peers.

4. Draw conclusions based on the comparison, but be aware of potential biases and limitations in your analysis.

Conclusion

In this section, the speaker concludes by advising viewers to understand relative valuation and keep it in their arsenal, even if they are true believers in intrinsic valuation.

Growth and Risk

In this section, the speaker discusses how to apply the multiple define describe analyze apply. The first step is defining the multiple, which involves ensuring that it is consistently defined.

Defining the Multiple

• Every multiple has a numerator and denominator, and they must be consistent. For example, if the numerator is an equity value, then the denominator must also be an equity value.

• The most widely used multiple in the world is EV/EBITDA because it is consistent. The numerator is market value of equity plus debt minus cash (a rough measure of operating assets), while the denominator is earnings before interest taxes depreciation and amortization (a rough measure of operating cash flows).

• If you mismatch your numerator/denominator, you will find companies that borrow a lot of money look cheap to you for all the wrong reasons.

Describing and Analyzing the Distribution

• When looking at a distribution of data for multiples, it's important to put it up in a histogram or distribution to get a sense of what's high, low, and typical.

• A multiple can never be lower than zero but can be very high. As such, when analyzing distributions with outliers on one side (asymmetric distributions), trust median over average.

• There are two questions to answer when analyzing a distribution: 1) What variables should determine that multiples? 2) How do changes in those variables affect my multiple?

Conclusion

The speaker emphasizes that analysts should not try to apply multiples without going through these steps as it can lead to trouble. It's important to ensure consistency in defining multiples and analyze their distributions carefully before making any conclusions about growth and risk.

Enterprise Valuation Model

In this section, the speaker discusses a simple enterprise valuation model that can be used to determine the price value of a company.

Simple Valuation Model

• The price value is determined by dividing the free cash flow to the firm next year by cost of capital minus growth rate.

• Algebraic calculations are required to determine the variables that drive each multiple.

Applying Multiples and Comparables

In this section, the speaker explains how to apply multiples and comparables in enterprise valuation.

Three Steps for Enterprise Valuation

• Define, describe, and analyze comparable firms with similar cash flows, growth rates, and risks.

• Control for differences in fundamentals beyond storytelling.

• Apply multiples and comparables.

Two Basic Questions for Applying Multiples and Comparables

• What are comparable firms?

• Comparable firms are companies with similar cash flows, growth rates, and risks.

• Think in fundamental terms rather than industry sectors.

• How can differences be controlled?

• Differences can be controlled through fundamental analysis beyond storytelling.

Importance of Knowing How to Use Multiples and Comparables

• Most people use relative valuation methods such as multiples and comparables.

• It is important to know how to use these methods even if you believe in intrinsic valuation.