The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit (Little Books. Big Profits)

by Aswath Damodaran

You make just as many assumptions when you do a relative valuation as you do in a discounted cash flow valuation. The difference is that the assumptions in a relative valuation are implicit and unstated, whereas those in discounted cash flow valuation are explicit and stated. In the intrinsic valuation chapter, we observed that the value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows. Every multiple, whether it is of earnings, revenues, or book value, is a function of the same three variables—risk, growth, and cash flow generating potential. Intuitively, firms with higher growth rates, less risk, and greater cash flow generating potential should trade at higher multiples than firms with lower growth, higher risk, and less cash flow potential. To look under the hood, so to speak, of equity and firm value multiples, we can go back to simple discounted cash flow models for equity and firm value and use them to derive the multiples.