In discounted cash flow valuation, the objective is to find the value of assets, given
their cash flow, growth and risk characteristics. In relative valuation, the objective is to
value assets, based upon how similar assets are currently priced in the market. While
multiples are easy to use and intuitive, they are also easy to misuse. Consequently, a series
of tests were developed that can be used to ensure that multiples are correctly used.
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
earnings, book values or sales. The second is to find similar firms, which is difficult to do
since no two firms are identical and firms in the same business can still differ on risk,
growth potential and cash flows. The question of how to control for these differences,
when comparing a multiple across several firms, becomes a key one.
Use of Relative Valuation
The use of relative valuation is widespread. Most equity research reports and many