Relative Valuation: Tests

1
Relative Valuation Tests
2
Information requirements

• An analyst tells you that he never does DCF
  valuation because it requires too many
  assumptions (about cash flows, growth and risk).
  He argues that it is far simpler to use a
  multiple (EV/EBITDA, PE etc), obtained by looking
  at other firms in the sector, to estimate value.
  Is he right?
• Yes
• No
• Explain.

3
Distributional assumptions

• If you estimate the PE ratio for all companies
  and graph out the frequency distribution, can the
  distribution be normal?
• Yes
• No
• Why not? So what?

4
Controlling variables?

• You are trying to decide whether a software
  company is fairly priced, based upon its PE
  ratio. The company trades at a PE ratio of 12 and
  the average for the software sector is 20. Based
  on this comparison, you would conclude that
• The stock is cheap
• The stock is expensive
• The stock is fairly priced
• State your implicit assumptions.