The
Little Book of Valuation The
Little Book of Valuation
The
two approaches to valuation – discounted cash flow valuation and relative
valuation – will generally yield different estimates of value for the
same firm at the same point in time. It is even possible for one approach to
generate the result that the stock is under valued while the other concludes
that it is over valued. Furthermore, even within relative valuation, we can
arrive at different estimates of value depending upon which multiple we use and
what firms we based the relative valuation on.
The
differences in value between discounted cash flow valuation and relative
valuation come from different views of market efficiency, or put more
precisely, market inefficiency. In discounted cash flow valuation, we assume
that markets make mistakes, that they correct these mistakes over time, and
that these mistakes can often occur across entire sectors or even the entire
market. In relative valuation, we assume that while markets make mistakes on
individual stocks, they are correct on average. In other words, when we value a
new software company relative to other small software companies, we are
assuming that the market has priced these companies correctly, on average, even
though it might have made mistakes in the pricing of each of them individually.
Thus, a stock may be over valued on a discounted cash flow basis but under
valued on a relative basis, if the firms used for comparison in the relative
valuation are all overpriced by the market. The reverse would occur, if an
entire sector or market were underpriced.