Financial markets are complex ecosystems, influenced by a multitude of factors that can range from economic conditions to investor sentiment. In this complex landscape, when it comes to making informed investment decisions, analysts and investors can employ various methods to assess the value of financial assets. Relative valuation, also known as comparable analysis is one such method which is widely used. In this article, we will explore the importance of relative valuation and provide a complete guide on how to apply it effectively.
Basic Definition
Remember the time when your parents compared your exam result with your much more capable sibling or when they told you to be like “Sharma Ji Ka Beta” or that particular time when your class-teacher reprimanded you for creating a ruckus in the classroom and compared you to a monkey! Well technically those are examples of relative valuation: You take a characteristic of something/someone (marks, manners, behavior in these personal cases) and compare it with its competitors or industry peers to assess its value. In the financial domain this equates to comparing the valuation of a target company to that of similar or a benchmark company with the primary objective of determining whether the company is overvalued, undervalued, or fairly priced relative to its peers.
Typically implemented using price multiples (Price/Earnings or Price/Book value) or enterprise multiples (Enterprise Value/ EBITDA), the basic idea underlying relative valuation is that similar assets should sell at similar prices. A classic example is pairs trading that utilizes pairs of closely related stocks (e.g., two automotive stocks), buying the relatively undervalued stock and selling short the relatively overvalued stock.
Importance
This importance of this valuation model is based upon the key advantages that it offers to its practitioners:
As we will see in the next section, it is relatively straightforward to apply with easily accessible data
Provides a market-based assessment of a company’s value so it’s more likely to reflect the current sentiment of the market
Fundamentally, it is based on a reasonably sound economic principle of similar assets selling at similar prices
From the analyst’s perspective, it is easier to explain to potential clients & the minimal use of assumptions makes it easier to defend in front of superiors.
Application
The application of this method can be broken down into the following steps:
Identify comparable companies: Stock screeners and company annual reports can be utilized to extract a list of similar firms. Sometimes, the broader market index can also be used to assess a company’s relative valuation
Gather financial data of both the target company and its industry peers
Calculate the relevant valuation multiples. These can be earnings or revenue based such as Price to earnings (P/E) and Price to Book Value (P/B) or they can be sector-specific as well for example Average Revenue Per User (ARPU) is a common metric used in the telecommunication sector so a Price/ARPU metric can be used.
Utilize the multiples to make the comparisons
Let’s take an example to see these steps in action:
I gathered the following data for the Diamonds/Gems & Jewellery sector from a stock screener.
|
Company Name |
Share Price |
Book Value per share |
Trailing 12 month Earnings per share |
Price / Book Value (P/B) |
Price /Earning (P/E) |
Industry P/E |
|
3,284.0 |
133.5 |
36.3 |
24.6 |
90.6 |
29.2 |
|
|
204.2 |
35.3 |
4.6 |
5.8 |
43.0 |
29.2 |
|
|
504.2 |
498.7 |
49.8 |
1.0 |
10.1 |
29.2 |
|
|
447.1 |
72.8 |
7.0 |
6.1 |
64.4 |
29.2 |
|
|
1,214.0 |
141.9 |
43.6 |
8.6 |
27.8 |
29.2 |
|
|
127.4 |
53.7 |
7.4 |
2.4 |
17.2 |
29.2 |
I would like to know how company A compares with the rest of its peers. Taking P/E as my choice of multiple, I find the average P/E of all the 6 companies in the sector which is 29.2. Using this, I can estimate a new fair value of Rs 1059.9 per share for company A [(Earnings of Rs 36.3 per share) X (Industry P/E of 29.2)] based on which company A appears to be overvalued compared to its peers.
We can then further examine company specific qualitative factors like management quality or growth prospects which can help us critique whether the valuation differences are justified and what investment decision needs to be taken.
Disadvantages
Like every valuation model, this also has certain disadvantages:
The model is backward-looking as it relies on historical data, which may not predict future performance accurately
Companies can manipulate ratios to appear more profitable than they are, leading to misleading valuations.
Industry bubbles can be easily overlooked. The Internet bubble of 2000’s serves as a classic example.
Concluding remarks
While relative valuation has its limitations and challenges, it does provide a practical and market-driven approach to quickly and easily get an idea of an assets value which is why it is an essential concept in the financial domain. The Wall Street School, through its flagship “Financial Modelling and Valuations program” and the “Stock Market Training Program“ not only covers relative and other valuation methods extensively but also provides in-depth practical understanding of other topics like financial modelling and technical analysis, which are essential to learn for candidates who want to make a career in finance and/or want to become better investors.
