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The Basic Concept Behind Relative Valuation

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The basic concept behind relative valuation or multiples is that identical assets should sell for 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 presents major shortfalls. First, market trading levels may be dependent on periods of irrational investor sentiment that will bias the valuation of the company either too high or low in comparison to similar companies. Second, this method can be easily manipulated. Different assumptions in the choice of the multiple metrics or peer group can result in distinct conclusions. Nonetheless, Fernández (2001) and Goedhart et al. (2005) agree that multiples provide useful insights in stress-testing the DCF model and knowledge about industry dynamics and its players.

Fernández (2001) divides multiples into three categories. The first is based on the firm’s market capitalization and include the price-to-earnings (P/E), price-to-equity book value (P/BV) and price-to-sales (P/S) ratios. Although widely used, Goedhart et al. (2005) pinpoint two major flaws in using P/E multiples: they are constantly affected by capital structure and are impacted by nonoperating items, such as one-time events. The second category is based on enterprise value (EV). The most common include the EV-to-EBITDA, EV-to-EBIT, and EV-to-Revenues. Finally, price-to-earnings growth or EV-to-EBITDA growth multiples are included in the last category, alluded to growth. These ratios are then multiplied by the company’s performance figures to estimate its share price.

Additionally, Goedhart et al. (2005) present four principles to properly value a company using multiples. First, the authors stress the importance of choosing peers with similar expectations regarding ROIC and growth. Second, they defend that the EV-to-EBITA ratio is superior to others since it is not affected by capital structure, unless material changes to the cost of capital occur, thus providing “a more apples-to-apples comparison” across company values (Koller et al., 2015). Third, they suggest the adjustment of this ratio for nonoperating items such as excess cash, operating leases, employee stock options and pensions. Lastly, they advise the use of forward-looking multiples based on “forecast rather than historical profits”.

Choosing the right peer group is crucial for a reasonable relative valuation. The relevant comparable companies must have similar business models and operations. Moreover, these companies must compete in the same markets, be exposed to the same macroeconomic environment and have similar prospects of growth and returns on capital (Foushee et al., 2012).

In consonance with Fernández (2001), the flexibility to delay an investment has value in itself and the real options approach tries to capture that while other methods such as the net present value and internal rate of return fail to do so. Disregarding this flexibility causes the undervaluation of lucrative projects (Fernández, 2001, and Michaels and Leslie, 1997).

Fernández (2001) classifies real options by categorizing them into three groups: contractual options, growth/learning options, and flexibility options. To value real options, both the Binomial and Black-Scholes models can be used (Fernández, 2001).

However, Damodaran (2012) notes that there are constraints on the use of option-pricing models. The constraints arise from the fact that assumptions need to be made over long periods of time, decreasing the precision of the estimation significantly.

Every company has its own characteristics so there is no single model that is able to accommodate all of those characteristics. This literature review allowed the determination of the best model to value ATVI. Therefore, the enterprise-DCF and EP models were the primary choices due to their wider influence and insight about economic performance. Also, ATVI is assumed to maintain a stable capital structure going forward. Finally, the relative valuation approach was also implemented as a complementary exercise to further robust the enterprise-DCF model. Hopefully, this review is able to present the major valuation models and, by recognizing their disadvantages, lay the foundation for further improvement in this discipline.

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The Basic Concept Behind Relative Valuation. (2018, December 03). GradesFixer. Retrieved December 9, 2022, from https://gradesfixer.com/free-essay-examples/the-basic-concept-behind-relative-valuation/
“The Basic Concept Behind Relative Valuation.” GradesFixer, 03 Dec. 2018, gradesfixer.com/free-essay-examples/the-basic-concept-behind-relative-valuation/
The Basic Concept Behind Relative Valuation. [online]. Available at: <https://gradesfixer.com/free-essay-examples/the-basic-concept-behind-relative-valuation/> [Accessed 9 Dec. 2022].
The Basic Concept Behind Relative Valuation [Internet]. GradesFixer. 2018 Dec 03 [cited 2022 Dec 9]. Available from: https://gradesfixer.com/free-essay-examples/the-basic-concept-behind-relative-valuation/
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