Aswath Damodaran 1

VALUATION: PACKET 2
RELATIVE VALUATION, ASSET-BASED
VALUATION AND PRIVATE COMPANY
VALUATION
Aswath Damodaran
9/2016 Updated: September 2016
 Test 1: Are you pricing or valuing?
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 Test 2: Are you pricing or valuing?
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 The Essence of Relative Valuation (Pricing)
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¨ In relative valuation, the value of an asset is compared to

the values assessed by the market for similar or
comparable assets.
¨ To do relative valuation then,
¤ we need to identify comparable assets and obtain market values
for these assets
¤ convert these market values into standardized values, since the
absolute prices cannot be compared This process of
standardizing creates price multiples.
¤ compare the standardized value or multiple for the asset being
analyzed to the standardized values for comparable asset,
controlling for any differences between the firms that might
affect the multiple, to judge whether the asset is under or over
valued

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 Relative valuation is pervasive…
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¨ Most asset valuations are relative.

¨ Most equity 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
¤ Rules of thumb based on multiples are not only common but are often
the basis for final valuation judgments.
¨ While there are more discounted cashflow valuations in
consulting and corporate finance, they are often relative
valuations masquerading as discounted cash flow valuations.
¤ The objective in many discounted cashflow valuations is to back into a
number that has been obtained by using a multiple.
¤ The terminal value in a significant number of discounted cashflow
valuations is estimated using a multiple.

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 Why relative valuation?
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“If you think I’m crazy, you should see the guy who
lives across the hall”
Jerry Seinfeld talking about Kramer in a Seinfeld episode

“ A little inaccuracy sometimes saves tons of explanation”

H.H. Munro

“ If you are going to screw up, make sure that you have
lots of company”
Ex-portfolio manager

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 The Market Imperative….
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¨ Relative valuation is much more likely to reflect market perceptions

and moods than discounted cash flow valuation. This can be an
advantage when it is important that the price reflect these
perceptions as is the case when
¤ the objective is to sell a security at that price today (as in the case of an
IPO)
¤ investing on “momentum” based strategies
¨ With relative valuation, there will always be a significant proportion
of securities that are under valued and over valued.
¨ Since portfolio managers are judged based upon how they perform
on a relative basis (to the market and other money managers),
relative valuation is more tailored to their needs
¨ Relative valuation generally requires less information than
discounted cash flow valuation (especially when multiples are used
as screens)

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 Multiples are just standardized estimates of price…
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Market value of equity Market value for the firm Market value of operating assets of firm
Firm value = Market value of equity Enterprise value (EV) = Market value of equity
+ Market value of debt + Market value of debt
- Cash

Numerator = What you are paying for the asset

Multiple =
Denominator = What you are getting in return

Revenues Earnings Cash flow Book Value

a. Accounting a. To Equity investors a. To Equity a. Equity
revenues - Net Income - Net Income + Depreciation = BV of equity
b. Drivers - Earnings per share - Free CF to Equity b. Firm
- # Customers b. To Firm b. To Firm = BV of debt + BV of equity
- # Subscribers - Operating income (EBIT) - EBIT + DA (EBITDA) c. Invested Capital
= # units - Free CF to Firm = BV of equity + BV of debt - Cash

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 The Four Steps to Deconstructing Multiples
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¨ Define the multiple

¤ In use, the same multiple can be defined in different ways by different
users. When comparing and using multiples, estimated by someone else, it
is critical that we understand how the multiples have been estimated
¨ Describe the multiple
¤ Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on
whether it is too high or low.
¨ Analyze the multiple
¤ It is critical that we understand the fundamentals that drive each multiple,
and the nature of the relationship between the multiple and each variable.
¨ Apply the multiple
¤ Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.

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 Definitional Tests
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¨ Is the multiple consistently defined?

¤ Proposition 1: Both the value (the numerator) and the
standardizing variable ( the denominator) should be to the same
claimholders in the firm. In other words, the value of equity
should be divided by equity earnings or equity book value, and
firm value should be divided by firm earnings or book value.
¨ Is the multiple uniformly estimated?
¤ The variables used in defining the multiple should be estimated
uniformly across assets in the “comparable firm” list.
¤ If earnings-based multiples are used, the accounting rules to
measure earnings should be applied consistently across assets.
The same rule applies with book-value based multiples.

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 Example 1: Price Earnings Ratio: Definition
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PE = Market Price per Share / Earnings per Share

¨ There are a number of variants on the basic PE ratio
in use. They are based upon how the price and the
earnings are defined.
Price: is usually the current price
is sometimes the average price for the year
EPS: EPS in most recent financial year
EPS in trailing 12 months
Forecasted earnings per share next year
Forecasted earnings per share in future year

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 Example 2: Staying on PE ratios
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¨ Assuming that you are comparing the PE ratios

across technology companies, many of which have
options outstanding. What measure of PE ratio
would yield the most consistent comparisons?
a. Price/ Primary EPS (actual shares, no options)
b. Price/ Fully Diluted EPS (actual shares + all options)
c. Price/ Partially Diluted EPS (counting only in-the-money
options)
d. Other

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 Example 3: Enterprise Value /EBITDA Multiple
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¨ The enterprise value to EBITDA multiple is obtained by

netting cash out against debt to arrive at enterprise
value and dividing by EBITDA.
Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation

1. Why do we net out cash from firm value?

2. What happens if a firm has cross holdings which are
categorized as:
¤ Minority interests?
¤ Majority active interests?

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 Example 4: A Housing Price Multiple
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The bubbles and busts in housing prices has led investors to

search for a multiple that they can use to determine when
housing prices are getting out of line. One measure that has
acquired adherents is the ratio of housing price to annual net
rental income (for renting out the same house). Assume that
you decide to compute this ratio and compare it to the multiple
at which stocks are trading. Which valuation ratio would be the
one that corresponds to the house price/rent ratio?
a.Price Earnings Ratio

b.EV to Sales

c.EV to EBITDA

d.EV to EBIT

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 Descriptive Tests
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¨ What is the average and standard deviation for this multiple,

across the universe (market)?
¨ What is the median for this multiple?
¤ The median for this multiple is often a more reliable comparison point.
¨ How large are the outliers to the distribution, and how do we
deal with the outliers?
¤ Throwing out the outliers may seem like an obvious solution, but if the
outliers all lie on one side of the distribution (they usually are large
positive numbers), this can lead to a biased estimate.
¨ Are there cases where the multiple cannot be estimated? Will
ignoring these cases lead to a biased estimate of the
multiple?
¨ How has this multiple changed over time?

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 1. Multiples have skewed distributions…
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PE Ratios: US companies in January 2016

700.

600.

500.

400.

300.

200.

100.

0.
0.01 To 4 4 To 8 8 To 12 12 To 16 16 To 20 20 To 24 24 To 28 28 To 32 32 To 36 36 To 40 40 To 50 50 To 75 75 To 100 100 and
over

Current Trailing Forward

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 2. Making statistics “dicey”
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Current PE Trailing PE Forward PE

Number of firms 7480 7480 7480
Number with PE 3,344. 3,223. 2,647.
Average 59.42 46.04 29.63
Median 18.53 18.29 16.98
Minimum 0.11 0.28 0.15
Maximum 32,269.00 6,900.00 2,748.00
Standard deviation 777.02 256.06 81.27
Standard error 13.44 4.51 1.58
Skewness 37.27 19.9 18.74
25th percentile 11.88 12.32 13.1
75th percentile 30.25 29.52 24.28

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US firms in January 2016
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3. Markets have a lot in common : Comparing Global PEs
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Trailing PE Ratios by Region

25.00% Average 25th perc. Median 75th perc.
United States 46.04 12.32 18.29 29.52
Europe 57.57 10.27 16.69 26.76 <4
Japan 29.83 9.96 15.08 24.93
4 To 8
Emerging Markets 91.08 9.57 16.77 39.69
20.00%
Aus, NZ & Canada 67.42 8.87 15.69 27.52 8 To 12
Global 71.16 10.00 16.69 32.07 12 To 16

16 To 20
15.00%
20 To 24

24 To 28

28 To 32
10.00%
32 To 36

36 To 40

40 To 50
5.00% 50 To 75

75 To 100

100 and over

0.00%
US Europe Japan Emerging Markets Aus, NZ & Canada Global

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 3a. And the differences are sometimes revealing…
Price to Book Ratios across globe – January 2013
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 4. Simplistic rules almost always break down…6
times EBITDA was not cheap in 2010…
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 But it may be in 2016, unless you are in Japan,
Australia or Canada
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EV/EBITDA Multiples in January 2016

25.00%

Average 25th perc. Median 75th perc.

United States 439.06 7.70 11.80 28.00
20.00% Europe 98.53 6.73 10.12 16.55
Japan 69.64 4.67 7.20 11.59
Emerging Markets 112.64 6.76 11.91 28.07
Aus, NZ & Canada 77.17 5.24 8.85 15.77
15.00% Global 148.16 6.43 10.58 21.67

10.00%

5.00%

0.00%
<2 2 To 4 4 To 6 6 To 8 8 To 10 10 To 12 12 To 16 16 To 20 20 To 25 25 To 30 30 To 35 35 To 40 40 To 45 45 To 50 50 To 75 75 To >100
100

US Europe Japan Emerging Markets Aus, NZ & Canada Global

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 Analytical Tests
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¨ What are the fundamentals that determine and drive these

multiples?
¤ Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
¨ How do changes in these fundamentals change the multiple?
¤ The relationship between a fundamental (like growth) and a multiple
(such as PE) is almost never linear.
¤ Proposition 3: It is impossible to properly compare firms on a multiple,
if we do not know how fundamentals and the multiple move.

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 A Simple Analytical device
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