Log In Relative Valuation Model: Definition & An Overview
Relative valuation is a valuation technique that helps investors determine the value of a company. They achieve this through comparison with similar companies. This technique uses ratios like P/E (price-to-earnings).
It is also helpful in situations where there is a large gap between the value of the company and the value of a comparable company.
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KEY TAKEAWAYS
- To determine a firm’s financial worth, a relative valuation model compares the value of a company to its competitors.
- The price-to-earnings (P/E), one of the most widely used relative valuation multiples, is also a popular one.
- A relative valuation model is different from an absolute one. The absolute valuation method looks exclusively at the financial performance of the company to calculate its future cash flows, without considering other companies or industry averages.
- A relative valuation model can be used to assess the company’s stock market value relative to other companies and averages.
What Is the Relative Valuation Model?
Relative valuation is one of the many forms of business valuation. It helps investors determine the value of a company when compared to similar companies. It is used to compare the company’s stock price in the market to other companies or an industry average. This method is relatively quick and useful when there is a group of similar entities.
Investors rely on this comparative price metric to determine the ratio of price compared to other companies in the same industry. It’s easy to compare the same types of firms, such as in the financial industry.
But what if a company does not have any comparables? This simply means that there is no other company in the same industry or sector that has the same unique value proposition. And the lack of comparables means that the company is probably unpriced.
If the company has a unique value proposition, it is not priced since you can’t value it through a comparison with other companies. Current share pricing is also only available for public companies. This could affect market prices, so be mindful.
On the other hand, if the company is currently undervalued, it could be because there are no comparable companies. In this case, the company’s valuation can be improved by estimating the value of other companies. But make sure that they have the same unique value proposition as the company.
You can use relative forms of valuation on public companies and private companies. Just keep in mind that it might be harder to determine future cash flows of private ones.
Types of Relative Valuations
The three most common types of relative valuations are P/E, E/V, and P/S, where:
P/E: Price-to-Earnings
E/V: Enterprise Valuation
P/S: Price-to-Sales
P/E ratios compare a stock’s price to its earnings. A high P/E ratio means that investors are paying a lot for each dollar of earnings, while a low P/E ratio means that they are paying less.
Moreover, many different factors affect P/E ratios. For example, earnings growth, expected future earnings, and inflation.
E/V ratios compare a company’s market value to its underlying assets and earnings. A high E/V ratio means that the company’s overvalued, while a low E/V ratio means that it’s undervalued.
P/S ratios compare a stock’s price to its sales. A high P/S ratio means that investors are paying a lot for each dollar of sales, while a low P/S ratio means that they are paying less.
P/S ratios are affected by many different factors, such as growth rates, expected future sales, and profitability.
Relative valuations are not perfect, however, and should not be used as the sole basis for investment decisions. Other factors, such as a company’s fundamentals, should also be considered
How to Calculate Relative Valuation?
There are many types of relative value ratios. These include price to free cash flow (EV), operating margin, and price to cash flow.
The price/earnings ratio is one of the most widely used relative valuation multiples. This ratio is calculated by multiplying stock price by earnings/share (EPS) and expressed as a multiple on a company’s earnings. A high P/E ratio means that a company gets valued at more per dollar than its peers.
A company with a low ratio of P/E is considered undervalued. It trades at a lower per-dollar EPS price and may be therefore considered a potential investment opportunity. To determine relative market value, you can use this framework with any number of prices.
If a company is trading at 5x earnings and the industry average P/E is 10x, then it is likely undervalued relative to its peers.
How to Use Relative Valuation Model?
The relative valuation model compares companies that are within a certain distance, such as a country or industry sector. To find the value of a company that does not have any comparable companies:
- First, the unpriced company is compared with other companies that are within the distance.
- Next, the major value of the comparable companies is used to estimate the value of the unpriced company.
- The unpriced company is then compared with other companies that are beyond the distance.
- Through this comparison, investors can get a better understanding of the company’s value.
- The investors can then decide whether they want to increase or decrease their investment in the company.
This is vital for investors to determine the value of a potential acquisition. In some cases, the relative valuation can be so low that the investor eventually backs out of the sale. Or in other cases, the relative valuation shows that the investment is worth more than anticipated.
Summary
A relative valuation model estimates the value of a company when compared to similar companies. It’s a good way for investors to get a rough idea of what to expect when positioning to invest or buy a company. From there, they must perform more intensive valuations to get a clear value of the business.
Frequently Asked Questions about Valuation Analysis
Relative valuation has limitations like any other valuation tool. The assumption that the market has correctly valued the business is the biggest limitation.
A relative valuation model can be used for assessing the company’s stock prices in relation to other companies and an industry average.
The relative valuation attempts to determine the value of a company by comparing it to similar companies. You use the same metric for companies within the same industry.
The biggest advantage is that relative valuations are quick and easy to perform.
A good example is choosing between a $500 smartphone and a $2,000 smartphone. Both provide the same features, but one is cheaper than the other. In this case, the pricier smartphone has poor relative value.
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