Module 8:

Relative
Valuation

Image source: Teju Finance - Relative valuation

Relative Valuation

• Relative valuation is a method used to determine the value of a company/asset by comparing it

to similar companies/assets. Here are five key points:
✓ Comparison-based: It involves comparing a company's valuation multiples (e.g., P/E ratio,
EV/EBITDA) to those of comparable firms in the same industry or sector.
✓ Market-driven: This approach relies on current market conditions and peer valuations,
reflecting what investors are willing to pay for similar assets.
✓ Multiple types: Common valuation multiples used include Price-to-Earnings (P/E), Price-to-
Sales (P/S), Enterprise Value-to-EBITDA (EV/EBITDA), and Price-to-Book (P/B) ratios.
✓ Benchmarking: The target company's multiples are compared to those of industry peers or
market averages to estimate its relative value.
✓ Simplicity: It provides a quick and straightforward valuation approach, but it assumes that the
market correctly values the peer companies and that these peers are truly comparable.
 DCF versus Relative Valuation
• Based on the present value of future cash flows
generated by the asset or business
Discounted cash
• Often used for companies with predictable cash flows
flow valuation and growth, such as established firms
(DCF)
• Depends on the accuracy of projections; complex and
time-consuming to prepare

• Values an asset by comparing it to similar assets; uses

market comparables such as price-to-earnings (P/E)
Relative ratios, price-to-sales (P/S) ratios, or enterprise value-to-
Valuation EBITDA ratios rather than intrinsic value
• Useful for benchmarking and new venture valuation
• Easier to apply and understand
 Relative Valuation: Examples

A prospective house buyer Valuing Company A based on its

decides how much to pay for a price-to-earnings ratio compared to
house by looking at the prices paid the average P/E ratio of its industry
for similar houses in the peers.
neighbourhood.

Tech
Industry

Image source: CFI relative valuation

Process of Relative Valuation
2. Scale Market Prices: 3. Adjust for Differences:
1. Find comparable Account for variations in
assets: Identify market- Convert the market value
into standardised fundamentals and other
priced assets similar to the factors that might affect
one being valued multiples like earnings, valuation across
book value, or revenues comparable assets

$$$
$$

Identify similar houses in the Compare prices per square Adjust prices based on differences
neighborhood that have foot of the houses to such as newer renovations,
recently sold standardize the values updated amenities etc.
Standardised Values and Multiples
• Comparing assets that are not exactly similar can be a
challenge
• To compare the values of similar firms in the market, we
need to standardise the values in some way by scaling them
to a common variable.
• In general, values can be standardised relative to the
earnings firms generate, to the book value or replacement
cost of the firms themselves, to the revenues that firms Image source: Stock Bros
generate, or to measures that are specific to firms in a
sector.
Standardised Values and Multiples
1. Earnings Multiples
➢ One of the more intuitive ways to think of the value of any
asset is as a multiple of the earnings that the asset
generates
➢ P/E ratio: When buying a stock, it is common to look at the
price paid as a multiple of the earnings per share (EPS)
generated by the company.
➢ P/E ratios can be current, trailing (based on the last four
quarters), or forward (projected for the next year).
➢ Business Valuation: Examine the value of the firm as a
multiple of EBIT or EBITDA

Image source: CFA Institute

Standardised Values and Multiples
2. Book Value or Replacement Value Multiples

➢ Book value is determined by accounting rules and reflects

the original cost of assets minus adjustments like
depreciation, while market value reflects what investors
are willing to pay for a stock
➢ Investors use the price-to-book ratio to assess whether a
stock is over- or undervalued, which can vary by industry
based on growth potential and investment quality.
➢ Replacement Cost Alternative: Tobin's Q measures the
ratio of the market value of the firm to the replacement
cost of its assets, offering an alternative to book value

Image source: CFI

Standardised Values and Multiples
3. Revenue Multiples
➢ Both earnings and book value are accounting
measures and are determined by accounting
rules and principles. An alternative approach,
which is far less affected by accounting choices,
is to use the ratio of the value of a business to
the revenues it generates.
➢ Price-to-sales (P/S) ratio for equity investors
and the enterprise value-to-sales (EV/S) ratio
for firm value
➢ Revenue multiples allow for easier comparison
between firms in different markets with varying
accounting systems

Image source: Wall street prep

Standardised Values and Multiples
4. Sector-specific multiples
Valuing E-Commerce Business
➢ These are valuation metrics tailored to specific
industries
➢ Examples: Valuing internet firms based on
market value per website hit or valuing cable
companies by market value per subscriber
➢ Sector-specific multiples can lead to over/under
valuations because they don't have broader
market benchmarks for comparison.
➢ It is hard to see how these multiples relate to
actual financial performance, turning website
hits into revenue.

Image source: FE International

 Four basic steps to using multiples
1. Definitional Tests 2. Descriptional Tests 3. Analytical Tests 4. Application Tests
Ensure everyone uses Know the range: what constitutes Determinants: Every Identify ‘comparable
high, low, and typical values for multiple (earnings, revenue, or
the same definition
multiple book value) depends on: Risk,
firm’: A comparable firm is one
Eg; P/E Ratio Variants: with cash flows, growth
growth, Cash flow potential
• Forward P/E: Used by bullish potential, and risk similar to the
Understand firm being valued.
analysts to highlight low
• Distributional characteristics of Relationship: understanding
future earnings multiples.
multiple how the multiple changes as the
• Current P/E: Used by Control for differences
• Average vs Median (given fundamentals change
bearish analysts to
emphasise high current that no upper limit of value) across firms:
earnings multiples. • Probabilistic statements Companion Variable: Each There are three ways of
• Outliers & averages valuation multiple is primarily controlling for differences:
Key Principles: • How do comp. deal with influenced by a key variable, subjective adjustments, modified
• Consistency outliers? called the companion variable, multiples, and statistical
• Numerator and • Biases in estimating multiples which best explains differences techniques.
Denominator (equity vs
• Adjust down, aggregate, across firms and varies
firm value)
different multiple depending on the multiple used.
• Uniformity
• Time variation in multiples
• If trailing for one let it
• Economic fundamentals like
be for all. 2.Accounting
interest rates, growth or
standards uniformity
market perception
The firm reported net income of $15 million on revenues of $150 million last year and equity invested of $75
million. The firm is expected to maintain these values in perpetuity.

The firm paid out 10% of its earnings as dividends, resulting in a retention ratio of 90%. Assume also that the
firm pays out its FCFE as dividends and that it is expected to maintain this payout ratio for the next five
years.

After the fifth year, we will assume that the expected growth rate in net income will drop to 4%.

We will assume that the beta for equity is 1.00 in perpetuity. With a risk-free rate of 5% and a market risk
premium of 4%.
Relationship between Multiples and Fundamentals

Growth Effect
• Other things remaining equal, companies with higher growth should trade at higher equity multiples.
• But what if the expected growth rate is different from our expectations?
• With PEG ratios, the ratio initially decreases as the expected growth increases, but after bottoming out at
one point, it begins rising again.
• PEG ratio does not fully control for differences in growth across companies
• Your decision may changed based on the expected growth you are taking.
• The effect of changes in the expected growth rate on equity multiples can also vary depending on the level
of interest rates.
Risk Effect
• Risk enters the equation through the cost of equity
• Holding other variables constant, increasing the risk of equity will decrease all equity
multiples

Quality of Investment

• Not all growth is created equal

• companies that generate growth more efficiently should trade at higher equity values than those which
generate the same growth less efficiently.
 Definition
Imagine a company called TechCorp. Over the past year, its earnings (profits) have been rising consistently,
which means it’s earning more each quarter.
Let’s say:
•TechCorp’s current stock price is $100.
•Current EPS (earnings per share): $5 (recent quarter’s data)
•Trailing 12-month EPS: $4.50
•Expected future EPS (forward EPS): $6

Consistency
Imagine two companies in the same industry:

Company A: No debt, EBITDA of $10 million, stock price (equity value) of $100 million.

Company B: High debt, EBITDA of $10 million, stock price (equity value) of $50 million.
Equity Value
Multiples

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Fundamentals Determining Equity Multiples
Firm Value versus Enterprise Value

• EV tells investors or interested parties a company’s value and how much another company would
need if it wanted to purchase that company.

• Enterprise value is used as the basis for many financial ratios that measure the performance of a
company.
Enterprise Value
Multiples

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Industry Specific
Multiples

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Reconciling relative valuation and DCF valuation

DCF assumes that markets make mistakes but eventually correct them over time, possibly
across entire sectors or markets.

In contrast, relative valuation assumes markets are correct on average, even if individual stocks
are mispriced.

Therefore, a stock might appear overvalued based on DCF but undervalued on a relative basis
if the market has generally overpriced comparable firms, and vice versa if the sector is
generally underpriced.