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Relative Valuation Methods and Distributional Assumptions in Financial Analysis

This text explores the validity of using multiples like EV/EBITDA and PE ratios in comparison to DCF valuation, along with distributional assumptions and controlling variables in financial analysis. It addresses the question of normality in PE ratio distribution and helps in determining fair pricing for a software company.

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Relative Valuation Methods and Distributional Assumptions in Financial Analysis

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  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.

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