Top Stories | Tue, 17 Dec 2024 12:24 PM

Relative Valuation: Measuring Worth by Comparing Value.

Posted by : SHALINI SHARMA

Generally, there are two approaches in the valuation methods. The two approaches are intrinsic valuation and relative valuation. Intrinsic valuation tries to determine an asset's fundamental value by calculating its cash flows and growth, whereas relative valuation measures value through comparison with similar entities in the market.

Relative valuation is one of the widely used techniques by investors, analysts, and other professionals in the finance sector. This technique is very simple and straightforward to apply; so, how does it work, and at which times does it seem more effective? In the blog post, let's dwell into the relative valuation procedure in detail and see step-by-step procedures showing us the process of using relative valuation in practice. Also, the strength and weakness will be discussed in relative valuation.

Common, former relative to which it is often called, involves either the comparable companies analysis or the market-based valuation whereby, through the bench marking the asset values will be arrived at comparing with similar asset s or similar companies. Where, it does not just derive intrinsic value based upon projections on the future that is involved here, for this derives its value base up on the multiples and also, Ratios driven on the market on value derivation basis.

The theory here is that comparable equities should sell for comparable prices. If the stock in a comparable company sells to a given multiple, in theory a comparable company should similarly sell to a similar multiple only adjusted for minor differences.

 Use  of Relative Valuation

Market Relevant: It captures real market perception and pricing

Time Saving: Much easier and quicker than in-depth intrinsic valuation models.

Very Useful for Comparisons: Helpful in comparing firms operating in the same line of business or industry.

Very useful for public markets. Especially when prices of the peer companies are readily available from the market.

1. What is Relative Valuation? 

Relative valuation is the process of calculating the value of an asset by taking into account the financial ratios and multiples of that asset with respect to the similar assets. Therefore, this approach reflects real-time market opinion and helps one know the company's value in relation to other similar companies. That has thus emerged as quite practical in the speedier valuations.

2. Difference Between Relative Valuation and Intrinsic Valuation? 

Relative valuation uses market-based multiples in which comparative companies are compared whereas intrinsic valuation calculates the value of an asset based on fundamental cash flows and growth estimates. Relative valuation is relatively quicker; however, intrinsic valuation provides deeper analysis. 

3. What are the Common Multiples Used in Relative Valuation? 

Common multiples include P/E, EV/EBITDA, P/S, P/B, and Dividend Yield. Each multiple is suited to different industries and business conditions.

4. What is the Price-to-Earnings (P/E) ratio? 

The P/E ratio is a ratio that compares a company's share price to its earnings per share (EPS). It measures how much investors are willing to pay for each dollar of earnings. Useful for evaluating profitable companies.

5. When to use P/E ratio? 

The appropriate use of the P/E ratio is by the stable-earnings firm or firms within a matured industry. The measure is used to aid the profitability or market attitude analysis on comparable firms.

6. What's Price-to-Book, P/B? 

This is the ratio of market value of a specific company in relation to its book value that is termed P/B or Price-to-book. Such values are usually compared in banks, the insurance industries, as well as those in the real estate sector. 

7. Which businesses use Price-to-Book? 

The P/B ratio works well in asset-intensive industries like banking, insurance, and real estate because the book value of the assets forms a huge percentage of the valuation.

8. What is the Price-to-Sales (P/S) ratio? 

The P/S ratio measures the market capitalization of the company in terms of revenue. It is useful in evaluating companies that do not make or have very little profit, such as a young startup.

9. When to use the P/S ratio? 

The P/S ratio is used when the company is not profitable yet, like in a tech startup. It uses the value based on revenues rather than earnings.

10. What is the EV/EBITDA ratio? 

EV/EBITDA is the comparison of enterprise value (debt + equity - cash) and EBITDA of the company. It is quite useful in comparing firms having different capital structures.

11. What is Enterprise Value (EV)? 

EV is the total value of the company, that is equity and debt minus cash. It is the total cost to buy an enterprise.

12. Which of the two are more preferred between EV/EBITDA and P/E in some contexts? Why? 

EV/EBITDA takes into account the level of debt of a firm, thus providing better comparison for firms having varying capital structure which is not so in case of P/E since it only uses the value of equity.

13. What is peer group in Relative Valuation? 

Peer group is made up of firms with the same model of business, industry, and financial characteristics. It provides a benchmark to compare valuation.

14. How do you select comparable companies? 

Select those with the same industry, size, growth rate, geographic focus, and business models. The closer to match, the more accurate is the comparison.

15. What is the median multiple, and why is it used? 

The middle value of peer multiples. The middle value minimizes the impact of outliers, and so there's a balance for benchmarking purposes.

16. What is the difference between an average and a median multiple? 

The former adds all the values together and would be affected by extreme numbers whereas the latter will represent the middle value and therefore would decrease the effect of extreme numbers.

17. What is expansion in multiple? 

Expansion of the multiple of a company means when the multiple of valuation increases on a positive note because of a growing market or expectation of growth, therefore the stock price also increases. 

18. What is multiple compression? 

Multiple compression occurs when the multiple of a company's valuation falls due to negative sentiment, lower growth, or market conditions that devalue it. 

19. How is Relative Valuation applied in M&A? 

It determines an appropriate value for a target company by comparing valuation multiples relative to similar acquisitions or peer companies in the market. 

20. What is a Dividend Yield multiple? 

Dividend Yield is measured as annuals dividends/Share price; it applies to income-driven investors. Dividend per share/ Share Price.