Why is valuation required?
It helps us to take investment decisions.
* If Estimated Value > Market Price, Buy
* If Estimated Value < Market Price, Don’t Buy
How can equity be valued?
* Relative Valuation
In discounted cash flow valuation, the objective is to find the value of an asset, given its cash flow, growth and risk characteristics. In relative valuation, we value an asset based upon how similar assets are currently priced in the market. A prospective house buyer decides how much to pay for a house by looking at the prices paid for similar houses in the neighborhood. In the same vein, a potential investor in a stock tries to estimate its value by looking at the market pricing of “similar” stocks. Consequently, there are two components to relative valuation. The first is that to value assets on a relative basis, prices have to be standardized, usually by converting prices into multiples of some common variable. The second is to find similar assets, which is difficult to do since no two assets are exactly identical. With real assets like antiques and baseball cards, the differences may be small and easily controlled for when pricing the assets. In the context of valuing equity in firms, the problems are compounded since firms in the same business can still differ on risk, growth potential and cash flows.
Relative valuation is pervasive…Most valuations on Wall Street are relative valuations. * Almost 85% of equity research reports are based upon a multiple and comparables. * More than 50% of all acquisition valuations are based upon multiples The popularity of relative valuation is due below mentioned advantages of it; a. It is less time and resource intensive than discounted cash flow valuation: Discounted cash flow valuations require substantially more information than relative valuation. For analysts who are faced with time constraints and limited access to information, relative valuation offers a less time intensive alternative.
b. It is easier to sell: In many cases, analysts, in particular, and sales people, in general, use valuations to sell stocks to investors and portfolio managers. It is far easier to sell a relative valuation than a discounted cash flow valuation. After all, discounted cash flow valuations can be difficult to explain to clients, especially when working under a time constraint – many sales pitches are made over the phone to investors who have only a few minutes to spare for the pitch. Relative valuations, on the other hand, fit neatly into short sales pitches. In political terminology, it is far easier to spin a relative valuation than it is to spin a discounted cash flow valuation.
c. It is easy to defend: Analysts are often called upon to defend their valuation assumptions in front of superiors, colleagues and clients. Discounted cash flow valuations, with their long lists of explicit assumptions are much more difficult to defend than relative valuations, where the value used for a multiple often comes from what the market is paying for similar firms. It can be argued that the brunt of the responsibility in a relative valuation is borne by financial markets. In a sense, we are challenging investors who have a problem with a relative valuation to take it up with the market, if they have a problem with the value.
d. Market Imperatives: Relative valuation is much more likely to reflect the current mood of the market, since it attempts to measure relative and not intrinsic value. Thus, in a market where all internet stocks see their prices bid up, relative valuation is likely to yield higher values for these stocks than discounted cash flow valuations. In fact, by definition, relative valuations will generally yield values that are closer to the market prices than...