Relative valuation

What Is Relative Valuation?

Relative valuation is an equity valuation method that estimates the value of an asset by comparing it to the market prices of similar assets. This approach, falling under the broader category of Valuation methods, relies on the principle that similar assets should trade at similar prices. Analysts use various valuation multiples, derived from comparable companies, to determine if a stock is undervalued, overvalued, or fairly valued. The goal of relative valuation is to establish a comparative benchmark rather than an absolute intrinsic value.

History and Origin

The concept of comparing assets to determine their worth has ancient roots, predating formal financial markets. Early forms of relative valuation could be seen in real estate or commodity trading, where prices were often set based on recent transactions of similar items. In modern finance, the systematic use of financial ratios for company valuation gained prominence with the development of public equity markets. As companies began reporting standardized financial statements, investors and analysts could more easily compare their performance and valuation metrics. This led to the widespread adoption of metrics like the price-to-earnings ratio (P/E ratio), which became a foundational tool in relative valuation. The U.S. Securities and Exchange Commission (SEC) provides resources explaining fundamental metrics like the P/E ratio, highlighting its role in gauging a stock's price relative to its past or other companies.⁷

Key Takeaways

• Relative valuation assesses an asset's worth by comparing it to similar assets in the market.
• It primarily uses valuation multiples derived from comparable companies.
• The method assumes that comparable assets should trade at comparable prices.
• It offers a quick and intuitive way to gauge whether an asset is overvalued, undervalued, or fairly valued.
• The approach is widely used in investment decisions and merger and acquisition analysis.

Formula and Calculation

Relative valuation does not employ a single universal formula but rather uses various multiples. The general approach involves selecting an appropriate multiple and applying it to the corresponding financial metric of the company being valued.

One common equity multiple is the Price-to-Earnings (P/E) ratio:

$\text{P/E Ratio} = \frac{\text{Share Price}}{\text{Earnings Per Share (EPS)}}$

To value a target company using this multiple, the formula is rearranged:

$\text{Estimated Share Price} = \text{Comparable Company P/E Ratio} \times \text{Target Company EPS}$

Here:

• Share Price represents the current market price of a company's stock.
• Earnings per share (EPS) is a company's profit allocated to each outstanding share of common stock.
• Comparable Company P/E Ratio is the average or median P/E ratio of a selected peer group.

Other commonly used multiples include:

• Enterprise Value (EV) / EBITDA: This multiple relates a company's total enterprise value to its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). It is particularly useful for comparing companies with different capital structures because it considers both equity and debt.
• Price-to-Book (P/B) Ratio: Compares a company's market price to its book value.
• Price-to-Sales (P/S) Ratio: Compares a company's market price to its revenue.

Interpreting the Relative Valuation

Interpreting relative valuation results requires careful consideration of the comparable companies chosen and the prevailing market conditions. If a company's multiple is significantly higher than that of its comparable peers or the industry average, it may suggest that the company is overvalued. Conversely, a lower multiple might indicate that the company is undervalued.

However, a higher or lower multiple does not automatically imply mispricing. Differences in growth prospects, profitability, risk, and operational efficiency can all justify variations in multiples. For instance, a company with superior cash flow generation or higher expected growth might justifiably trade at a higher multiple. Analysts must normalize financial metrics to ensure an "apples-to-apples" comparison when interpreting relative valuation results.⁶ Understanding these nuances is crucial for making informed portfolio management decisions.

Hypothetical Example

Imagine an investor wants to value "Tech Innovations Inc.," a private software company, using relative valuation. They identify three publicly traded comparable companies: "Software Solutions Co.," "CodeCraft Ltd.," and "Digital Dynamics Corp."

First, the investor gathers financial data for the comparable companies and calculates their P/E ratios:

• Software Solutions Co.: Share Price = $50, EPS = $2.50. P/E = 50 / 2.50 = 20x
• CodeCraft Ltd.: Share Price = $75, EPS = $3.00. P/E = 75 / 3.00 = 25x
• Digital Dynamics Corp.: Share Price = $60, EPS = $2.70. P/E = 60 / 2.70 = 22.22x (approximately)

Next, the investor calculates the average P/E ratio for the comparable group:
(20 + 25 + 22.22) / 3 = 22.41x

Now, the investor determines the EPS for Tech Innovations Inc., which is $2.00. Using the average P/E multiple from the comparable companies, they estimate Tech Innovations Inc.'s per-share value:

Estimated Share Price for Tech Innovations Inc. = 22.41 (average P/E) × $2.00 (Tech Innovations EPS) = $44.82

This hypothetical example illustrates how relative valuation can provide a benchmark for a company's value based on its market peers, a process often referred to as comparable company analysis. This allows for a quick assessment compared to other companies, a key aspect of fundamental analysis.

Practical Applications

Relative valuation is a cornerstone of financial analysis and finds numerous practical applications across different facets of investing and corporate finance. Investment bankers frequently use it in merger and acquisition (M&A) deals to determine potential acquisition prices and assess fairness opinions. Equity research analysts rely on it to issue "buy," "sell," or "hold" recommendations for publicly traded stocks, often comparing a company's market capitalization to its earnings or revenue.

Furthermore, fund managers utilize relative valuation to identify potential mispricings within a sector or broader market, helping them construct portfolios that are potentially undervalued relative to their peers. For instance, a Reuters report highlighted Microsoft's valuation milestone, reaching $4 trillion in market value, demonstrating how market multiples reflect investor sentiment and company performance in real-time. ⁵Corporate finance professionals also use relative valuation to assess the value of private companies for capital raising, strategic partnerships, or internal decision-making. The ability to quickly assess value based on market data makes relative valuation an indispensable tool for analysts navigating dynamic market environments. Investors should be aware that analysts often use forward-looking earnings estimates, rather than historical profits, for these comparisons.

Limitations and Criticisms

While relative valuation offers simplicity and speed, it comes with notable limitations. A primary criticism is its inherent reliance on the assumption that the market correctly values the comparable companies. If the entire sector or market is overvalued (as might occur during a speculative "bubble"), then a relative valuation will simply reflect and perpetuate that overvaluation rather than identify it. For example, Morningstar, a prominent investment research firm, has faced discussions regarding the consistency and justification of its fair value estimates, particularly when market enthusiasm drives significant stock price changes.
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Another limitation is the challenge of finding truly comparable companies. No two companies are identical; differences in business models, growth rates, geographic exposure, accounting policies, and risk profiles can distort comparisons. Adjusting for these differences can be complex and introduce subjective judgments. Furthermore, relative valuation is often backward-looking, relying on historical or current financial data, which may not accurately reflect future prospects. ³Critics argue that this method does not provide an intrinsic value for a company but rather a relative value within the current market context. Morgan Stanley research has also highlighted that valuation multiples have lost some relevance over time due to shifts in how companies invest, particularly regarding intangible assets, and differences in capital structure.
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Relative Valuation vs. Discounted Cash Flow (DCF) Valuation

Relative valuation and discounted cash flow (DCF) valuation are two primary approaches to valuing an asset, often viewed as complementary rather than mutually exclusive. The fundamental difference lies in their underlying philosophy:

While relative valuation answers "What is this asset worth compared to others?", DCF valuation answers "What is this asset fundamentally worth?" ¹Many analysts employ both methods to arrive at a more robust valuation estimate, using relative valuation to cross-check DCF results and understand market positioning.

FAQs

What are the most common multiples used in relative valuation?

The most common multiples include the Price-to-Earnings (P/E) ratio, Enterprise Value-to-EBITDA (EV/EBITDA), Price-to-Sales (P/S), and Price-to-Book (P/B) ratios. The choice depends on the industry and the specific characteristics of the companies being analyzed. For example, revenue multiples might be used for companies with negative earnings.

How do I choose comparable companies for relative valuation?

Choosing comparable companies, or "comps," involves identifying publicly traded firms with similar business operations, industry, size, growth prospects, and financial risk profiles. It's often difficult to find perfectly identical companies, so analysts typically select a group of peers and make adjustments for key differences. Industry classification and financial performance are key factors in selecting appropriate comparables.

Can relative valuation be used for private companies?

Yes, relative valuation can be applied to private companies. Analysts will identify publicly traded companies that are similar to the private company and use their valuation multiples to estimate the private company's value. However, adjustments may be needed to account for differences in liquidity, size, and access to capital between public and private entities, often factoring in a liquidity discount.

Is relative valuation better than discounted cash flow (DCF) valuation?

Neither relative valuation nor DCF valuation is inherently "better"; they serve different purposes and offer distinct insights. Relative valuation is quick and reflects market sentiment, making it useful for rapid benchmarking. DCF, on the other hand, provides a theoretical intrinsic value based on future cash flows, which can be more robust for long-term investment decisions. Many financial professionals use both methods to achieve a comprehensive understanding of an asset's worth.

What are the challenges of using relative valuation?

Challenges include finding truly comparable companies, the risk of inheriting market mispricings (e.g., valuing a company within an overvalued sector), and the difficulty in accounting for unique company-specific factors not captured by simple multiples. Differences in accounting methods can also skew comparisons.