Understanding Relative Valuation

Valuation is a complex exercise. Investors usually employ various methods to assess the true worth of a company before making crucial investment decisions. One such method that provides a comparative perspective is relative valuation. It is also known as Comparable Company Valuation Method or Multiples based valuation. This approach evaluates a company’s value by comparing it with similar companies with similar operating performance (Growth, Return on invested capital etc).

In this article, we will delve into the nuances of relative valuation, exploring what it is, how to perform it, its advantages, and comparing it with other valuation methods like Asset Based Valuation and Discounted Cash Flow (DCF) Valuation. We will also explore the limitations that investors need to be aware of when using a relative valuation.

What is Relative Valuation?

Relative valuation, also known as comparable company analysis (CCA) or multiples valuation, involves assessing the value of a company by comparing it to similar companies in the same industry or sector. Instead of relying on intrinsic factors like discounted cash flows or book values, relative valuation looks at how the market values businesses similar businesses (Businesses of similar size, same industry and similar performance – growth, Return on invested capital etc)

How to Perform Relative Valuation?

• Select Comparable Companies/ Peers – Identify companies that are similar to the one being analyzed in terms of industry, size, growth prospects, and risk profile.
• Choose Valuation Multiples – The second step is to choose appropriate valuation multiples. There are different multiples which can be used depending on the industry, Company maturity etc. For Industrial Companies, Enterprise value multiples like EV/NOPLAT, EV/EBITA, EV/EBITDA multiples are considered best for valuation purposes. For Financial Services (Banking, Broking, Insurance Companies) Equity multiples like P/E (Price to Earnings multiple) is generally used. For immature Companies, ie; Startups or Companies with negligible profits/ cash flows Price/Sales or Price to Book multiples are generally used. Therefore one should select multiples which are relevant for the particular industry/ Company.
• Calculate Multiples for Comparable Companies – The next step is to calculate the relevant multiples (as discussed above) for the comparable companies. Multiples (Like P/E ratio, Price to Book value) for listed entities are usually available on external sources like – Bloomberg, Yahoo Finance.
• Apply Multiples to the Target Company – Apply the average or median multiples from the comparable companies to the corresponding financial metric of the target company to estimate its valuation.

Advantages of Relative Valuation

• Easy to understand – Relative valuation is often more straightforward and easier to understand compared to complex models like Discounted Cash Flow.
• Market Perception –  It captures the market’s perception and expectations (Future Growth, Margins, Return on invested capital etc.), reflecting current sentiment and trends within the industry.
• Industry Comparison – Relative valuation allows investors to compare a company against its peers within the same industry, providing a more contextually relevant assessment.

Limitations of Relative Valuation

• Reliance on Market Sentiment – Since relative valuation depends on market prices and multiples, it can be influenced by short-term market sentiment, leading to fluctuations in perceived value.
• Industry Averages – Using Industry average multiples of comparable companies assumes that the industry averages accurately reflect the true value. However, industry dynamics and outliers can skew these averages.
• Limited Precision – Relative valuation provides a useful estimate but lacks the precision of intrinsic valuation methods. It is a tool for quick assessments rather than a standalone, definitive measure.

Conclusion

In the ever-evolving landscape of finance, relative valuation emerges as a valuable tool for investors seeking a quick, industry-specific assessment of a company’s worth. Its simplicity and accessibility make it an attractive choice for market participants. However, it’s essential to acknowledge its limitations and use it in conjunction with other valuation methods to gain a comprehensive understanding of a company’s true value.

As a finance and strategy consultant, integrating relative valuation into your toolkit allows for a more versatile and adaptive approach to assessing investment opportunities. By considering the advantages, comparing with other methods, and understanding its limitations, you can leverage relative valuation effectively in your financial analyses, aiding clients in making well-informed decisions in an ever-changing market environment.