Question

Discuss and explain the merits and limitations of using the method of comparables as a valuation method.

Answer 1

The two major valuation methods used are:

1. Discounted Cash Flow (DCF) Method
2. Comparable method

DCF Method:

Discounted Cash Flow method, also known as Present Value Model, works on assumption that value depends on the future cash flows. This can be used when the future benefits can be reasonably estimated.

Comparables Method:

Comparables method, also known as multiples method, evaluates the value of company using the parameters of other businesses in same industry (Eg. Companies that have similar earnings or revenue or asset base). Various multiples such as Price Earnings ratio (P/E), Price to Sales ratio (P/S), etc are used to estimate the value of the company. This method works on the assumption that similar businesses in the industry will have similar ratios.

The merits and limitations of Comparables method are as follows:

Merits	Limitations
Easy to apply and so investors find the method easy to understand.	Difficult to find similar business with similar revenue or earnings.
Fewer assumptions are used when compared to DCF method.	Difficulty in selection of ratio to use.
The estimation is based on the real market data.	This method is not suitable for stocks that are not regularly traded.
Comparables method also considers current situation of the market	Sometimes, similar businesses may have different ratios, which is against the assumption of Comparable method.