If you need to determine the value of firms within your industry, there are two fundamental value analysis techniques to choose from. Discounted flow valuation has you analyzing details and making a series of assumptions about the intrinsic worth of a firm, calculating the company’s worth based on how much money it projects to earn minus a discount for what that money will be worth in the future. The more commonly used relative valuation techniques determine the value of a company based on the value of similar companies.
The differences between using ratios and relative value analysis technique for valuing firms versus discounted cash flow can be both a strength and a weakness. It takes less time and resources to delve into, and it’s easier to sell or defend because it’s predicated on an “everybody’s doing it” argument, but the market determines a company's value because all other similar companies are worth that much. Before carrying out company comparisons, walk through three steps:
1. Determine whether relative valuation is right for you.
2. Develop a scale to standardize prices based on a common variable.
3. Adjust for differences between the assets under comparison using similar assets already priced in the market.
Decide whether to use ratio evaluations when comparing firmsWhile you can save considerable time and effort using the relative valuation technique, keep a close watch on market behavior. If the market has been either overly optimistic or pessimistic, it will over- or under-value all assets, including the ones under consideration.
Conduct a ratio evaluation to decide which yardstick you want to useWhile analysts commonly refer to EBITDA ratios (Earnings Before Interest, Taxes, Depreciation, Amortization), you actually have several ratios to choose from, such as price to earnings ratio (P/E), price to sales ratio (P/S), even ratios based on book value or replacement cost. Review the various ratios and understand their relative merits before you continue your evaluation, then stick with those ratios to maintain consistency across your appraisals.
Aswath Damodaran hosts a site with a comprehensive glossary of valuation ratios you can use to compare companies.