The dangers of relative valuation

In my last post on Twitter, I hypothesized that the valuation of Twitter was based upon what investors had assigned as a value for Facebook a few months earlier. I want to make clear that I am not suggesting that this is a good way to value businesses but that it is the status quo.

With relative valuation, the dangers of a bad initial valuation cascading into subsequent valuations is high and they get worse when the initial valuation is of a large company (Facebook is large, by the standards of networking sites) and done by what is viewed as a reputable source (private equity investors have an ill deserved reputation for valuation expertise and a big investment banking name helps..) In fact, this may be one reason for pricing bubbles in sectors.

I can carry the relative valuation lessons here to an absurd limit. I have 15,000 + members on the mailing list for my website (damodaran.com). I would argue that this is a fairly valuable potential list for anyone with an investment or valuation product. Applying the $32.5/member to each member (a bargain, given the selection bias), my site should be worth half a million. Any takers? Better still, why not just your add your name to my mailing list and increase my value $32.5 by doing so? (The incentives for sites to seek out new members, even if they are idle and do nothing, is extremely high...)

I am kidding here, since I have no intent of making my site commercial. I have always argued that relative valuation, at least as it is practiced, is a sign of laziness because analysts are not only sloppy but throw out much of the data that they have access to. Relative valuation, done right, where you use not just the averages, but also look at the differences in valuations across companies to draw lessons about how the market values assets, can be a very useful tool in valuation.