How do you choose between relative and absolute valuation methods?

1 Relative valuation

Relative valuation is a method that compares the value of a business to similar or comparable businesses in the same industry or market. The most common way to do this is to use multiples, such as price-to-earnings (P/E), price-to-book (P/B), or enterprise value-to-EBITDA (EV/EBITDA). These multiples express the ratio of a market-based measure of value (such as price or enterprise value) to a financial metric (such as earnings, book value, or EBITDA). The idea is to find the average or median multiple for a group of comparable businesses, and then apply it to the target business to get its value.

Relative valuation is simple, intuitive, and widely used by investors and analysts. It can also reflect the market sentiment and expectations for a particular sector or industry. However, relative valuation also has some drawbacks. It relies on the availability and quality of comparable data, which may not always be accurate, consistent, or relevant. It also assumes that the multiples are representative of the intrinsic value of the businesses, which may not be true if there are differences in growth, risk, profitability, or capital structure. Moreover, relative valuation can be influenced by market fluctuations, bubbles, or anomalies, which may distort the true value of a business.

2 Absolute valuation

Absolute valuation is a method that tries to estimate the intrinsic or fundamental value of a business based on its future cash flows, earnings, or assets. The most common way to do this is to use discounted cash flow (DCF) analysis, which projects the free cash flow of a business over a certain period, and then discounts it back to the present using an appropriate discount rate. The discount rate reflects the risk and opportunity cost of investing in the business. The sum of the discounted cash flows is the present value of the business.

Absolute valuation is more rigorous, objective, and consistent than relative valuation. It does not depend on external factors or assumptions about the market or the industry. It also captures the unique characteristics and potential of a business, such as its growth prospects, competitive advantages, or synergies. However, absolute valuation also has some challenges. It requires a lot of inputs and estimates, which may not be readily available or reliable. It also involves a lot of uncertainty and sensitivity, as small changes in the assumptions or projections can have a big impact on the value. Moreover, absolute valuation can be complex, time-consuming, and difficult to explain or communicate to others.

4 Applying the methods effectively

Valuing a business is an art that requires skill, experience, and creativity. To get a reliable and meaningful valuation, you need to apply the chosen method effectively. When using relative valuation, select the most relevant and comparable businesses, multiples, and data sources. Adjust for any differences in size, growth, risk, profitability, or capital structure. Use more than one multiple to get a broader perspective and avoid outliers or biases. For absolute valuation, use realistic and consistent assumptions and projections with an appropriate discount rate that reflects the risk and opportunity cost of your business. Test the sensitivity and robustness of your valuation to different scenarios and variables. Moreover, update your valuation regularly to reflect changes in the market conditions, industry trends, or business performance. Lastly, use common sense and judgment to interpret and communicate your results.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?