Relative valuation models

What Is Relative Valuation Models?

Relative valuation models are a financial tool used to estimate the value of a company or asset by comparing it to similar companies or assets in the market. This approach falls under the broader category of investment valuation, which seeks to determine the fair worth of an investment. Instead of relying solely on a company's internal financial characteristics, relative valuation models gauge whether a stock appears overvalued, undervalued, or fairly priced relative to others in its field. The core assumption is that comparable assets should trade at similar valuation multiples, given similar underlying characteristics and financial performance.

Common metrics employed in relative valuation models often include ratios derived from a company's share price or Enterprise Value in relation to key financial figures like Earnings per Share, revenue, or EBITDA⁴⁰, ⁴¹. These valuation multiples summarize the relationship between a company's market value and a fundamental quantity, providing a quick and easily communicable assessment³⁹.

History and Origin

The concept of relative valuation, though not formalized in early financial theory, has been implicitly used by investors for centuries as a natural way to compare assets. The foundation of relative valuation models is rooted in the "law of one price," which suggests that identical assets should sell for the same price. As financial markets evolved and data became more accessible, practitioners began to systematize this comparative approach using various financial ratios.

The widespread adoption and refinement of relative valuation models, particularly through methods like Comparable Company Analysis, gained significant traction in the 20th century with the growth of modern corporate finance and investment banking. These models became essential shortcuts for analysts seeking to quickly assess a company's value against its peers, especially in the context of mergers and acquisitions and initial public offerings³⁷, ³⁸.

Key Takeaways

• Relative valuation models estimate a company's worth by comparing its financial metrics and valuation multiples to those of similar public companies or past transactions.
• The primary assumption is that comparable assets, given similar risk and growth profiles, should trade at similar valuations.
• Common methods include Comparable Company Analysis (Comps) and Precedent Transaction Analysis (Precedents).
• Key multiples used include Price-to-Earnings (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), Price-to-Book (P/B), and Price-to-Sales (P/S).
• Relative valuation provides a market-based perspective, reflecting current market sentiment and industry trends.

Formula and Calculation

Relative valuation models primarily involve the calculation and comparison of various financial ratios, or valuation multiples. While there isn't a single universal "formula" for relative valuation, the process typically involves calculating a chosen multiple for a target company and then comparing it to the median or average of a peer group.

A widely used equity multiple is the Price-to-Earnings Ratio:

This ratio indicates how much investors are willing to pay for each dollar of a company's earnings³⁶.

Another common enterprise value multiple is the Enterprise Value-to-EBITDA (EV/EBITDA) ratio:

This multiple relates the total value of the company, including its debt, to its earnings before interest, taxes, depreciation, and amortization, making it useful for comparing companies with different capital structures³⁵.

Analysts typically calculate these multiples for a set of comparable companies and then apply the median or average multiple from that set to the target company's corresponding financial metric to arrive at an implied valuation³⁴.

Interpreting the Relative Valuation Models

Interpreting the output of relative valuation models involves comparing the target company's calculated multiples to those of its peers. For instance, if a company's Price-to-Book Ratio is significantly lower than the average of its comparable companies, it might suggest that the company is undervalued relative to its assets³², ³³. Conversely, a higher multiple could indicate that the company is overvalued or that investors anticipate higher future growth or profitability compared to its peers³¹.

It is crucial to consider qualitative factors alongside the quantitative comparisons. Differences in business models, growth prospects, financial performance, and risk profiles among companies in a peer group can justify variations in multiples. For example, a company with strong competitive advantages or superior management might warrant a higher Equity Value multiple than a competitor.

Hypothetical Example

Consider a hypothetical scenario where an analyst is valuing "InnovateTech Inc.," a private software company, using relative valuation models.

Step 1: Identify Comparable Companies
The analyst identifies three publicly traded software companies (Comp A, Comp B, Comp C) that operate in a similar niche, have comparable revenue sizes, and similar growth profiles.

Step 2: Gather Financial Data and Calculate Multiples
The analyst collects financial data for the comparable companies, including their current Market Capitalization, Enterprise Value, trailing 12-month revenue, and EBITDA.

Step 3: Apply Multiples to InnovateTech Inc.
InnovateTech Inc. has a trailing 12-month revenue of $150 million and EBITDA of $35 million. The analyst decides to use the median multiples from the comparable companies.

• Implied Enterprise Value (using EV/Revenue) = InnovateTech's Revenue × Median EV/Revenue $$= \$150 \text{ million} \times 8.0\text{x} = \$1,200 \text{ million}$$
• Implied Enterprise Value (using EV/EBITDA) = InnovateTech's EBITDA × Median EV/EBITDA $$= \$35 \text{ million} \times 33.3\text{x} \approx \$1,165.5 \text{ million}$$

By applying these relative valuation models, the analyst establishes a valuation range for InnovateTech Inc. between approximately $1,165.5 million and $1,200 million, based on the financial performance of its peers.

Practical Applications

Relative valuation models are widely used across the financial industry for various purposes due to their simplicity and market-driven insights. They are a staple in:

• Investment Banking: Professionals frequently use Comparable Company Analysis (Comps) for mergers and acquisitions (M&A), initial public offerings (IPOs), and other corporate finance advisory services. ²⁹, ³⁰They also employ Precedent Transaction Analysis (Precedents) to analyze historical deals involving similar companies and ascertain the premiums paid.
  ²⁷, ²⁸* Equity Research: Analysts use relative valuation models to assess whether publicly traded stocks are overvalued or undervalued, generating "buy," "sell," or "hold" recommendations for investors.
• Portfolio Management: Fund managers use relative valuation to identify attractive investment opportunities and make asset allocation decisions by comparing potential investments across sectors and industries.
• Corporate Development: Companies undertaking strategic acquisitions or divestitures use these models to benchmark potential targets or assets.
• Valuation for Private Companies: While direct comparisons can be challenging, relative valuation provides a framework for valuing private businesses by finding publicly traded equivalents.

For example, when evaluating a company for a potential acquisition, an investment banker might look at the multiples paid in recent, similar transactions as a key input to determine a fair price. This helps reflect prevailing market sentiment regarding comparable assets. Firms can find relevant financial information and filings for publicly traded companies on the U.S. Securities and Exchange Commission's (SEC) EDGAR database, which is crucial for conducting a thorough comparable company analysis.
²⁶

Limitations and Criticisms

Despite their widespread use, relative valuation models have several limitations and criticisms:

• Reliance on Market Efficiency: Relative valuation assumes that the market accurately prices the comparable companies. If the entire peer group is overvalued or undervalued, applying their multiples will lead to a misvaluation of the target company. ²⁵As Warren Buffett's favorite indicator, the total market capitalization to GDP ratio, can sometimes signal broad market overvaluation, reliance on relative models during such periods might be misleading.
  ²³, ²⁴* Finding True Comparables: Identifying truly comparable companies can be challenging. Businesses often have unique characteristics, different stages of growth, varying capital structures, and diverse geographic exposures that make direct comparisons difficult. ²¹, ²²A technology company in its high-growth phase, for instance, may not be accurately valued against a mature, stable tech company using the same multiples.
  ¹⁹, ²⁰* Backward-Looking vs. Forward-Looking: While analysts often use forward-looking metrics for greater accuracy, multiples can still reflect a "snapshot" in time rather than capturing future growth potential or strategic shifts. ¹⁷, ¹⁸This can be particularly problematic for companies undergoing significant business model changes or operating in rapidly evolving industries.
  ¹⁶* Ignores Intrinsic Value Drivers: Relative valuation models do not explicitly consider the fundamental drivers of a company's Intrinsic Value, such as its future cash flows, competitive advantages, or management quality. Critics argue that this approach can sometimes be a "short-cut" that oversimplifies complex business realities.
  ¹⁵* Subjectivity in Peer Selection and Adjustments: The selection of the peer group and the adjustments made for differences among comparable companies can introduce significant subjectivity and bias into the valuation process.
  ¹³, ¹⁴

Relative Valuation Models vs. Discounted Cash Flow (DCF) Models

Relative valuation models and Discounted Cash Flow (DCF) models are two fundamental approaches to company valuation, often used in conjunction to provide a comprehensive assessment. The key distinction lies in their underlying philosophy and methodology.

W¹¹hile relative valuation models offer a quick and intuitive way to assess a company's value against its peers, DCF models aim to determine a company's absolute intrinsic value based on its expected future cash-generating ability. Warren Buffett, for instance, emphasizes calculating intrinsic value through discounted future cash flows rather than solely relying on multiples. Many⁸, ⁹, ¹⁰ analysts and investors use both approaches to triangulate a more robust valuation, combining market context with a deep dive into fundamental value drivers.

FAQs

What are the main types of relative valuation models?

The two main types of relative valuation models are Comparable Company Analysis (Comps) and Precedent Transaction Analysis (Precedents). Comp⁷s involve comparing a company to currently publicly traded peers, while Precedents analyze historical merger and acquisition transactions of similar companies.

Why are relative valuation models popular?

Relative valuation models are popular because they are relatively simple to understand and implement, provide a quick assessment of a company's value, and directly incorporate current market sentiment. They⁵, ⁶ offer a market-based perspective, showing how investors are currently pricing similar assets.

What are some common financial ratios used in relative valuation?

Common financial ratios, or valuation multiples, used in relative valuation include the Price-to-Earnings Ratio (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), Price-to-Book Ratio (P/B), and Price-to-Sales (P/S). Thes⁴e ratios compare a company's market price or Enterprise Value to a specific financial metric.

Can relative valuation models be used for private companies?

Yes, relative valuation models can be adapted for valuing private companies. This typically involves identifying publicly traded companies that are as similar as possible to the private company in terms of industry, size, growth, and profitability. The multiples derived from these public comparables can then be applied to the private company's financial figures to estimate its Equity Value or Enterprise Value.

###³ What is the biggest drawback of relative valuation?
The biggest drawback is the inherent assumption that the market accurately values the comparable companies. If the entire industry or market segment is experiencing a bubble or downturn, relying solely on relative valuation could lead to an inaccurate assessment of the target company's true worth.¹, ²