littlebook The Little Book of Valuation

Reconciling Relative and Discounted Cash Flow Valuations

            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.