What Is a Relative Valuation Model?
A relative valuation model is a business valuation method that compares a company's value to that of its competitors or industry peers to assess the firm's financial worth.
Relative valuation models are an alternative to absolute value models, which try to determine a company's intrinsic worth based on its estimated future free cash flows discounted to their present value, without any reference to another company or industry average. Like absolute value models, investors may use relative valuation models when determining whether a company's stock is a good buy.
Key Takeaways
- A relative valuation model compares a firm's value to that of its competitors to determine the firm's financial worth.
- One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio.
- A relative valuation model differs from an absolute valuation model which makes no reference to any other company or industry average.
- A relative valuation model can be used to assess the value of a company's stock price compared to other companies or an industry average.
Understanding Relative Valuation Models
There are many different types of relative valuation ratios, such as price to free cash flow, enterprise value (EV), operating margin, price to cash flow for real estate and price-to-sales (P/S) for retail.
One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is calculated by dividing stock price by earnings per share (EPS), and is expressed as a company's share price as a multiple of its earnings. A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued.
Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued. This framework can be carried out with any multiple of price to gauge relative market value. Therefore, if the average P/E for an industry is 10x and a particular company in that industry is trading at 5x earnings, it is relatively undervalued to its peers.
One of the most common metrics in relative valuation models is the P/E, or price-to-earnings ratio. This is calculated by dividing a company's stock price by its annual earnings per share.
Relative Valuation Model vs. Absolute Valuation Model
Relative valuation uses multiples, averages, ratios,and benchmarks to determine a firm's value. A benchmark may be selected by finding an industry-wide average, and that average is then used to determine relative value. An absolute measure, on the other hand, makes no external reference to a benchmark or average. A company's market capitalization, which is the aggregate market value of all of its outstanding shares, is expressed as a plain dollar amount and tells you little about its relative value. Of course, with enough absolute valuation measures in hand across several firms, relative inferences can be drawn.
Example of Relative Valuation Model
In addition to providing a gauge for relative value, the P/E ratio allows analysts to back into the price that a stock should be trading at based on its peers. For example, if the average P/E for the specialty retail industry is 20x, it means the average price of stock from a company in the industry trades at 20 times its EPS.
Assume Company A trades for $50 in the market and has anEPS of $2. The P/E ratio is calculated by dividing $50 by $2, which is 25x. This is higher than the industry average of 20x, which means Company A is overvalued. If Company A were trading at 20 times its EPS, the industry average, it would be trading at a price of $40, which is the relative value. In other words, based on the industry average, Company A is trading at a price that is $10 higher than it should be, representing an opportunity to sell.
Because ofthe importance of developing an accurate benchmark or industry average, it is important to only compare companies in the same industry and market capitalization when calculating relative values.
What Are the Assumptions of Relative Valuation Models?
Relative valuation models assume that companies that operate in the same business sector will have similar cost structures and market conditions. This makes it possible to make reliable comparisons between two competing companies based on their profit margins, cash flow, sales, and other metrics.
What Are the Limitations of Relative Valuation Models?
One limitation of relative valuation models is that they assume similar businesses will face the same market conditions. While this is true to a point, competing companies often pursue different strategies and target different markets, meaning that it is not always possible to produce an apples-to-apples comparison. In addition, relative valuation models tend to rely on past financial statements, which are not always reliable predictors of future results.
How Do You Value a Business?
Business valuation is a major element of corporate financed, used to measure the value of a company before mergers, acquisitions, and public offerings. In order to value the business, analysts will examine a company's financials to determine its assets, liabilities, capital structure (the amount of stocks and bonds issued), cash flows, and other investments to produce an objective valuatio for the company.
The Bottom Line
A relative valuation model compares the value of similar companies in the same market segment. Based on comparable metrics like cash flow and earnings, it is possible to determine if a company uses its resources more or less effectively than its competitors.
