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Market Approach Valuation

Relative Valuation
RAVI
Market approach

• The market approach, as the name implies,


relies on signs from the real market place to
determine what a business is worth.
• Here, the so-called economic principle of
competition applies:
• What are other businesses worth that are
similar to my business?
Market Approach
• No business operates in a vacuum. If what you
do is really great then chances are there are
others doing the same or similar things.
• If you are looking to buy a business, you
decide what type of business you are
interested in and then look around to see
what the “going rate” is for businesses of this
type.
Market Approach
• If you are planning to sell your business, you
will check the market to see what similar
businesses sell for.
• It is intuitive to think that the “market” will
settle to some idea of business price
equilibrium - something that the buyers will
be willing to pay and the sellers willing to
accept.
• That’s what is known as the fair market value:
Market approach contd.
• The business price that a willing buyer will
pay, and a willing seller will accept for the
business.
• Both parties are assumed to act in full
knowledge of all the relevant facts, and
neither being under compulsion to conclude
the sale.
Market approach contd.
• So the market approach to valuing a business is a
great way to determine its fair market value – a
monetary value likely to be exchanged in an
arms-length transaction, when the buyer and
seller act in their best interest.
• Market data is great if you need to support your
offer or asking price – after all, if the “going rate”
is this much, why would you offer more or accept
less?
Market Approach Valuation
• In this method, the value is determined by
comparing the subject, company or assets
with peers or transactions happening in the
same industry and preferably of the same size
and region. This is also known as relative
valuation.
(i) Comparing companies multiples approach:
(ii ) Comparing transactions multiples approach:
(iii) Market Value approach - Most preferred approach in
terms of frequently traded shares companies
What is Relative Valuation ?
• Relative valuation, also referred to
as comparable valuation, is a very useful and
effective tool in valuing an asset.
• Relative valuation involves the use of similar,
comparable assets in valuing another asset.
Relative Valuation
Prices can be standardized using a common variable such as earnings, cashflows, book
value, or revenues.
- Earnings Multiples
• Price/Earning ratio (PE) and variants
• Value/EBIT
• Value/EBDITA
• Value/Cashflow
• Enterprise value/EBDITA
- Book Multiples
• Price/Book Value (of equity) PBV
- Revenues
• Price/Sales per Share (PS)
• Enterprise Value/Sales per Share (EVS)
- Industry Specific Variables (Price/kwh, Price per ton of steel, Price per click,
Price per labor hour)

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Multiples can be misleading

To use a multiple inelegantly you must:


• Know what are the fundamentals that determine the
multiple.
• Know how changes in these fundamentals change the
multiple.
• Know what the distribution of the multiple looks like.
• Ensure that both the denominator and numerator
represent claims to the same group
• - OK: P/E – Price  equityholders, EPS 
equityholders
• - Not OK: P/EBIT – Price equityholders, EBIT  All
claimants
• Ensure that firms are comparable.
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Relative vs. Fundamental Valuation
The DCF model of valuation is a fundamental method.
• Value of firm (equity) is the PV of future cash flows.
• Ignores the current level of the stock market
(industry).
• Appropriate for comparing investments across
different asset classes (stocks vs. bond vs. real estate,
etc).
• In the long run, fundamental is the correct way of
value any asset.

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Relative vs. Fundamental Valuation
Relative valuation is based on P/E ratios and a host of other
“multiples”.
• Extremely popular with the press, CNBS, Stock brokers
• Used to value one stock against another.
• Can not compare value across different asset classes (stocks
vs. bond vs. real estate, etc).
• Can not answer the question is the “stock market over
valued?”
• Can answer the question, “I want to buy a tech stock, which
one should I buy?”
• Can answer the question, “Which one of these overpriced
IPO’s is the best buy?”

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