{"id":3184,"date":"2025-04-25T21:46:23","date_gmt":"2025-04-25T16:16:23","guid":{"rendered":"https:\/\/www.thewallstreetschool.com\/blog\/?p=3184"},"modified":"2025-04-25T21:46:23","modified_gmt":"2025-04-25T16:16:23","slug":"relative-valuation-what-is-it-why-is-it-important-how-to-apply-it","status":"publish","type":"post","link":"https:\/\/www.thewallstreetschool.com\/stg-new\/relative-valuation-what-is-it-why-is-it-important-how-to-apply-it\/","title":{"rendered":"Relative Valuation: What is it? Why is it Important? How to apply it?"},"content":{"rendered":"
\n
\n

Financial markets are complex ecosystems, influenced by a multitude of factors<\/span> that can range<\/span> from economic conditions to investor sentiment. In this <\/span>complex<\/span> landscape, <\/span>w<\/span>hen it comes to making informed investment decisions, analysts and investors <\/span>can <\/span>employ various methods to assess the value of <\/span>financial <\/span>assets<\/span>. Relative valuation, also known as comparable analysis <\/span>is <\/span>one such method which is widely used.<\/span> In this article, we will explore the importance of relative valuation and provide a complete guide on how to apply it effectively.<\/span><\/p>\n

Basic Definition<\/span><\/h3>\n

Remember the time when your parents compared your exam result with your <\/span>much more capable <\/span>sibling<\/span> or when they told you to be like \u201cSharma Ji Ka Beta\u201d 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<\/span> 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.<\/span><\/p>\n

Typically implemented using<\/span> 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 <\/span>pairs trading<\/span> that utilizes pairs of closely related stocks (e.g., two automotive stocks), buying the relatively undervalued stock and selling short the relatively overvalued stock.<\/span><\/p>\n

Importance<\/span> <\/span><\/h3>\n

Th<\/span>is importance of this valuation model<\/span> <\/span>is based upon the <\/span>key <\/span>advantages that it offers to its <\/span>practitioners:<\/span><\/p>\n

As we will see in the next section, it is relatively straightforward to apply with easily accessible data<\/span><\/p>\n

Provides a market-based assessment of a company\u2019s value<\/span> <\/span>so it\u2019s more likely to reflect the current sentiment of the market <\/span><\/p>\n

Fundamentally, it is based on a <\/span>reasonably <\/span>sound economic principle <\/span>of<\/span> similar assets sell<\/span>ing<\/span> at similar prices<\/span><\/p>\n

From the analyst\u2019s perspective, it is easier to explain to potential clients & the minimal use of assumptions makes it easier to defend in front of superiors.<\/span><\/p>\n

Application<\/span><\/h3>\n

The application of this method can be broken down into the following steps:<\/span><\/p>\n

Identify comparable companies: Stock screeners and company annual reports can be utilized to extract a list of similar firms<\/span>. Sometimes, the broader market index can also be used to assess a company\u2019s relative valuation<\/span><\/p>\n

Gather financial data of both the target company and its industry peers<\/span><\/p>\n

Calculate the relevant valuation multiples. These can be earnings or revenue <\/span>based such as Price to earnings (P\/E) and Price to Book Value (P\/B)<\/span> or they can be sector-specific as well for e<\/span>xample Average Revenue Per User (ARPU) is a common metric used in the telecommunication sector so a Price\/ARPU metric can be used.<\/span><\/p>\n

Utilize the multiples to make the comparisons<\/span><\/p>\n

Let\u2019s take an example to see these steps in action:<\/span><\/p>\n

I<\/span> gathered the following data for the Diamonds\/Gems & Jewellery sector from a stock screener.<\/span><\/p>\n<\/div>\n<\/div>\n

\n
\n\n\n\n\n\n\n\n\n<\/colgroup>\n\n\n\n\n\n\n\n\n
<\/p>\n
\n

Company Name<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

Share Price<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

Book Value per share <\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

Trailing 12 month Earnings per share<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

Price \/ Book Value<\/span> (P\/B) <\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

Price<\/span> <\/span>\/Earning<\/span> (P\/E) <\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

Industry P<\/span>\/<\/span>E<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n

<\/p>\n<\/p>\n
\n

3,284.0<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

133.5<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

36.3<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

24.6<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

90.6<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

29.2<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n

<\/p>\n<\/p>\n
\n

204.2<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

35.3<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

4.6<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

5.8<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

43.0<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

29.2<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n

<\/p>\n<\/p>\n
\n

504.2<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

498.7<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

49.8<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

1.0<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

10.1<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

29.2<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n

<\/p>\n<\/p>\n
\n

447.1<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

72.8<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

7.0<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

6.1<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

64.4<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

29.2<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n

<\/p>\n<\/p>\n
\n

1,214.0<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

141.9<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

43.6<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

8.6<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

27.8<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

29.2<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n

<\/p>\n<\/p>\n
\n

127.4<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

53.7<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

7.4<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

2.4<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

17.2<\/span><\/p>\n<\/div>\n<\/td>\n

<\/p>\n
\n

29.2<\/span><\/p>\n<\/div>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

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, <\/span>I can <\/span>estimate <\/span>a<\/span> <\/span>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)]<\/span> based on which<\/span> company <\/span>A <\/span>appears to be overvalued compared to its peers. <\/span><\/p>\n

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.<\/span><\/p>\n

Disadvantages<\/span><\/h3>\n

Like every valuation model, this also has certain disadvantages:<\/span><\/p>\n

The model is backward-looking as it relies on historical data, which may not predict future performance accurately<\/span><\/p>\n

Companies can manipulate ratios to appear more profitable than they are, leading to misleading valuations.<\/span><\/p>\n

Industry bubbles can be easily overlooked. The Internet bubble of 2000\u2019s serves as a classic example.<\/span><\/p>\n

Concluding remarks<\/span><\/h3>\n

While relative valuation has its limitations and challenges,<\/span> <\/span>it<\/span> <\/span>does <\/span>provide a practical and market-driven <\/span>approach <\/span>to <\/span>quickly and easily <\/span>get a<\/span>n <\/span>idea of <\/span>an assets value<\/span> which<\/span> is why it<\/span> is an essential concept in the financial domain. The Wall Street School<\/span>, through its <\/span>flagship <\/span>\u201c<\/span>Financial Model<\/span>l<\/span>ing and Valuations program<\/span>\u201d<\/span> and t<\/span>he<\/span> <\/span>\u201c<\/span>Stock Market <\/span>T<\/span>raining<\/span> <\/span>Program\u201c not only covers relative and other valuation methods extensively but also provides in-depth <\/span>practical <\/span>understanding of <\/span>other topics like financial modelling <\/span>and<\/span> technical analysis, which are <\/span>essential to learn for<\/span> candidates<\/span> who want to make a career<\/span> in finance<\/span> <\/span>and\/<\/span>or want to become better investo<\/span>rs.<\/span><\/p>\n<\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"

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 […]<\/p>\n","protected":false},"author":38,"featured_media":3185,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[670],"tags":[],"class_list":["post-3184","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-financial-modeling"],"_links":{"self":[{"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/posts\/3184","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/users\/38"}],"replies":[{"embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/comments?post=3184"}],"version-history":[{"count":0,"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/posts\/3184\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/media\/3185"}],"wp:attachment":[{"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/media?parent=3184"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/categories?post=3184"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/stg-new\/wp-json\/wp\/v2\/tags?post=3184"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}