DCF VS Relative Valuations

DCF VS Relative Valuations

Despite the utility of Discounted Cash Flows model to arrive at the intrinsic value of a business, many analysts/investors continue to assume the 𝐃𝐂𝐅 𝐦𝐨𝐝𝐞𝐥 𝐚𝐬 𝐚 𝐭𝐡𝐞𝐨𝐫𝐞𝐭𝐢𝐜𝐚𝐥 𝐢𝐧𝐭𝐞𝐥𝐥𝐞𝐜𝐭𝐮𝐚𝐥 𝐞𝐱𝐞𝐫𝐜𝐢𝐬𝐞. As a result, they are comfortable to price business using multiples. Thus, multiples like 𝐏/𝐄, 𝐄𝐕/𝐄𝐁𝐈𝐓𝐃𝐀, 𝐚𝐧𝐝 𝐄𝐕/𝐒𝐚𝐥𝐞𝐬 have become popular.

I think pricing firms using the multiples is not wrong if we identify comparable firms with the 𝐬𝐢𝐦𝐢𝐥𝐚𝐫 𝐟𝐮𝐧𝐝𝐚𝐦𝐞𝐧𝐭𝐚𝐥 𝐜𝐡𝐚𝐫𝐚𝐜𝐭𝐞𝐫𝐢𝐬𝐭𝐢𝐜𝐬 (𝐠𝐫𝐨𝐰𝐭𝐡, 𝐫𝐢𝐬𝐤, 𝐚𝐧𝐝 𝐩𝐚𝐲𝐨𝐮𝐭) as the target business.

For instance, if i use a P/E multiple to identify the undervalued stock, then.

Market Value of Target firm = Earnings of the target firm * P/E multiple of comparable firms

𝐀𝐭 𝐧𝐨 𝐠𝐫𝐨𝐰𝐭𝐡,

Price = Earnings/Cost of equity

Dividing Earnings into both sides,

Price/Earnings = 1/Cost of Equity

At 10% cost of equity, P/E = 10 as the firm pays 100% as dividends and does not reinvest for growth.

𝐀𝐭 𝐜𝐨𝐧𝐬𝐭𝐚𝐧𝐭 𝐠𝐫𝐨𝐰𝐭𝐡 𝐨𝐟 𝟓%, for $1 of earnings and a 10% payout.

At 𝟏𝟎% 𝐩𝐚𝐲𝐨𝐮𝐭, 𝐫𝐨𝐞 = 𝟓%/(𝟏-𝟏𝟎%) = 𝟔%

𝐏𝐫𝐢𝐜𝐞/𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 = 𝟏(𝟏+𝟓%)(𝟏-𝟏𝟎%)/(𝟏𝟎%-𝟓%) = 𝟐.𝟏

Here, the 𝐏/𝐄 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐞 𝐫𝐞𝐝𝐮𝐜𝐞𝐬 despite the firm growing at 5% because the 𝐫𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲 𝐢𝐬 𝐥𝐞𝐬𝐬 𝐭𝐡𝐚𝐧 𝐭𝐡𝐞 𝐜𝐨𝐬𝐭 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲. Thus, analysts 𝐠𝐢𝐯𝐞𝐬 𝐭𝐨𝐨 𝐦𝐮𝐜𝐡 𝐟𝐨𝐜𝐮𝐬 𝐨𝐧 𝐄𝐏𝐒 𝐠𝐫𝐨𝐰𝐭𝐡 without considering if the growth creates value or destroys value. Thus, firms like Zomato 𝐰𝐢𝐥𝐥 𝐜𝐨𝐧𝐭𝐢𝐧𝐮𝐞 𝐭𝐨 𝐝𝐞𝐬𝐭𝐫𝐨𝐲 𝐯𝐚𝐥𝐮𝐞 𝐢𝐟 𝐭𝐡𝐞𝐲 𝐨𝐯𝐞𝐫𝐠𝐫𝐨𝐰 𝐰𝐢𝐭𝐡𝐨𝐮𝐭 𝐩𝐫𝐨𝐯𝐢𝐝𝐢𝐧𝐠 𝐚 𝐩𝐚𝐭𝐡𝐰𝐚𝐲 𝐭𝐨 𝐩𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲.

Thus, when comparing firms with different P/E ratios, the 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐞𝐬 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐰𝐢𝐭𝐡 𝐭𝐡𝐞 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐠𝐫𝐨𝐰𝐭𝐡 𝐫𝐚𝐭𝐞 𝐚𝐧𝐝 𝐩𝐚𝐲𝐨𝐮𝐭 𝐫𝐚𝐭𝐢𝐨 𝐚𝐧𝐝 𝐝𝐞𝐜𝐫𝐞𝐚𝐬𝐞 𝐰𝐢𝐭𝐡 𝐡𝐢𝐠𝐡 𝐫𝐢𝐬𝐤.

Thus, pricing companies by multiples follows the DCF valuation with the only difference that the 𝐚𝐬𝐬𝐮𝐦𝐩𝐭𝐢𝐨𝐧𝐬 𝐢𝐧 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐞𝐬 𝐚𝐫𝐞 𝐢𝐦𝐩𝐥𝐢𝐜𝐢𝐭.

We can price businesses rightly by comparing them to the right business with similar underlying fundamentals. But unfortunately, I have observed that analysts misprice target businesses by comparing them to the wrong firms resulting in poor valuations.