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

by Aswath Damodaran

The issues that make discounted cash flow valuation difficult also crop up, not surprisingly, when we do relative valuation and listed next are a few of them. Comparable firms: Even if all of the companies in a sector are growth firms, they can vary widely in terms of risk and growth characteristics, thus making it difficult to generalize from industry averages. Base year values and choice of multiples: If a firm is a growth firm, the current values for scaling variables such as earnings, book value, or revenues may provide limited or unreliable clues to the future potential for the firm. Controlling for growth differences: Not only does the level of growth make a difference to value, but so does the length of the growth period and the excess returns that accompany that growth rate. Put another way, two companies with the same expected growth rate in earnings can trade at very different multiples of these earnings. Controlling for risk differences: Determining how the trade-off between growth and risk will affect value is difficult to do in any valuation but becomes doubly so in relative valuation, where many companies have both high growth and high risk. Analysts who use multiples to value growth firms may feel a false sense of security about their valuations, since their assumptions are often implicit rather than explicit. The reality, though, is that relative valuations yield valuations that are just as subject to error as discounted cash flow valuations. Valuation Solu...