Reading: The Challenges of Relative Valuation
We have seen that the application of relative valuation is rather straightforward, since all it takes is a value indicator and a valuation multiple of a comparable firm. However, the simplicity that makes relative valuation so attractive also poses its greatest challenge: If we pick the "wrong" comparables or an "inadequate" value driver, the result of the valuation exercise will only by coincidence correspond to the fair value of the company. Moreover, since relative valuation treats the firm as a black box (that is, we do not really try to understand the mechanics that contribute to value creation), it will generally be difficult to understand how reliable the result of the valuation exercise actually is.
Consequently, whehter or not relative valuation produces a meaningful result depends on the following three questions:
- How to choose comparable firms?
- How to pick valuation multiples?
- What are the implicit assumptions about the valuation situation?
In what follows, we discuss these questions in more detail and provide some guidelines for the practical implementation of relative valuation.