What is Relative Valuation?

Relative valuation is a method of valuing an asset by comparing it to the market values of similar or comparable assets. The main concept is determining if an investment is overvalued or undervalued in relation to its peers.

Let’s learn what relative valuation is and delve into its technicalities.

What is Relative Valuation? 

Relative valuation is a method for determining a company’s value by comparing it with similar companies within the same industry or geographical region. 

Relative Valuation Methods require a number of important steps.

• Locate Comparable Assets: This entails locating assets that are comparable to the asset under analysis in terms of size, industry, kind, and other relevant factors.
• Obtain Market prices: The next stage after identifying comparable assets is to ascertain their current market prices. Stock prices, capitalisation, and other pertinent market measures may be examples of this.
• Standardise Market Values: It is impossible to compare the exact prices of various assets directly. As a result, a common financial metric must be used to standardise market values. The process of standardisation gives rise to price multiples.
• Compare Standardised Values: The asset under analysis’s standardised value, or multiple, is contrasted with those of the related assets. Adjustments are made for variations in growth rates, risk profiles, and accounting methods among the firms that could impact these multiples. This comparison aids in determining the asset’s valuation—whether it is overpriced or undervalued.

Relative Valuation Model Example

Let’s illustrate this method with an example from the Diamonds/Gems & Jewellery sector using the Price/Earnings (P/E) ratio.

Suppose we have data for six Diamond/Gems & Jewellery sector companies. If Company A has an earnings per share (EPS) of Rs 36.3 and the industry average P/E is 29.2, its fair value is Rs 1,059.9 per share. If its current share price is Rs 3,284, it appears overvalued compared to its peers.

Relative Valuation Techniques for Standardising Values

In order to turn market values into price multiples, standard variables such as earnings, cash flows, book value, or revenues are used in the standardisation process. Distinct multiples have distinct functions and offer different insights.

Earnings Multiples

• Price/Earnings Ratio (PE): The market price-to-earnings ratio per share, or PE, is the ratio between the market price and earnings
• Value/EBIT: It is the enterprise value divided by profits before interest and taxes for the company
• Value/EBITDA: The ratio of an organisation’s enterprise value to its earnings before interest, taxes, depreciation, and amortisation is known as value/EBITDA
• Value/Cash Flow: The proportion of an organisation’s operating cash flow to its enterprise value

Book Value Multiples

• Price/Book Value of Equity (PBV): The ratio of market price per share to book value per share
• Value/Book Value of Assets: The ratio of the firm’s enterprise value to the book value of its assets
• Value/Replacement Cost: The ratio of market value to the replacement cost of assets

Revenue Multiples

• Price/Sales per Share (PS): The market price ratio per share to sales per share
• Value/Sales: The firm’s enterprise value ratio to its total sales
• Industry-Specific Multiples: Certain industries have unique metrics relevant for valuation, such as price per kilowatt-hour (kWh) for utilities or price per ton of steel for steel companies

Calculation of Relative Valuation

• There are various relative value ratios, such as price to free cash flow (EV), operating margin, and price to cash flow
• The price/earnings (P/E) ratio is a popular relative valuation multiple
• To calculate the P/E ratio, divide the stock price by earnings per share (EPS)
• The P/E ratio is expressed as a multiple of the company’s earnings
• A high P/E ratio indicates that a company is valued higher per dollar of earnings than its peers
• A company with a low P/E ratio is undervalued, trading at a lower price per dollar of EPS, and may be a potential investment opportunity
• This framework is applied to compare companies to determine relative market value

For example, if a company’s P/E ratio is 5x and the industry average is 10x, it is likely undervalued compared to its peers

Advantages of Relative Valuation

• Comparison within Similar Groups: Relative valuation compares companies within the same country or industry sector, providing context-specific insights
• Valuing Unique Companies: For companies without direct comparables, the model allows for comparison with companies within a similar range
• Estimation Using Comparable Companies: By using the significant values of similar companies, investors can estimate the value of the unpriced company
• Extended Comparison: The model also compares the unpriced company with those beyond the immediate range, offering a broader perspective
• Enhanced Understanding: Investors better understand the company’s value through these comparisons
• Informed Investment Decisions: Investors can increase or decrease their investment based on the relative valuation, making it crucial for assessing potential acquisitions
• Risk Assessment: If the relative valuation is low, investors might back out, reducing potential losses
• Identifying Opportunities: Investors may find the investment more attractive if the valuation indicates higher potential

Types of Relative Valuation

There are three most common types of relative valuations:

Price-to-Earnings (P/E)

Definition: This ratio compares a stock’s price to its earnings.

Interpretation: 

• A high P/E ratio means investors pay a lot for each rupee of earnings
• A low P/E ratio means investors pay less for each rupee of earnings

Influencing Factors: 

• Earnings growth
• Expected future earnings
• Inflation

Enterprise Value (E/V)

Definition: This ratio compares a company’s market value to its underlying assets and earnings.

Interpretation: 

• A high E/V ratio indicates the company might be overvalued
• A low E/V ratio suggests the company might be undervalued

Price-to-Sales (P/S)

Definition: This ratio compares a stock’s price to its sales.

Interpretation:

• A high P/S ratio means investors pay a lot for each sales rupee
• A low P/S ratio means investors pay less for each sales rupee

Influencing Factors:

• Growth rates
• Expected future sales
• Profitability

Conclusion

Hence, you now know what relative valuation is. It is a practical and market-driven approach to determining a company’s value by comparing it to similar companies. It is easy to apply, relies on accessible data, and provides a current market sentiment-based assessment. 

However, it has limitations, such as reliance on historical data and potential manipulation of financial ratios. Despite these drawbacks, relative valuation remains a fundamental tool in economic analysis and investment decision-making.

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