How to perform relative valuation: A step-by-step approach?
Valuing a company can feel like trying to predict the weather—there’s a lot at play, and no one has a crystal ball. But just like meteorologists use data to make educated guesses, investors rely on methods like relative valuation to figure out a company’s worth. It’s simpler than it sounds, and by following the right steps, you can gain valuable insights to inform your investment decisions. Wondering how relative valuation techniques stack up in real-world applications? home page links investors with experts who can dive into the nuances of this valuation approach.
What is relative valuation?
Relative valuation is the process of comparing a company to other similar companies to determine its value. Unlike discounted cash flow (DCF) methods, which estimate value based on future projections, relative valuation looks at how much other companies are paying for similar businesses.
To perform relative valuation, you focus on multiples—ratios like price-to-earnings (P/E), price-to-sales (P/S), or price-to-book (P/B). These ratios give you a snapshot of how the market values a company in comparison to its competitors. For example, if a company has a P/E ratio of 10, but its competitors have an average P/E of 15, it might be undervalued.
Step 1: Identify comparable companies
The first step in relative valuation is to find companies that are similar to the one you’re analyzing. These should be in the same industry, operate in similar markets, and have a comparable size. The more similar, the better.
For example, if you’re looking at a tech company, you’d want to compare it to other tech companies—especially those that are similarly established, in the same geographical area, and with similar growth rates. You want apples-to-apples comparisons, not apples-to-oranges.
It’s important to ensure that your comparison group makes sense, as picking the wrong peers can lead you astray. A company that operates in a niche market might not compare well to a larger, more diversified firm. Always double-check the fundamentals of the companies you’re comparing.
Step 2: Choose the right multiples
Once you have your comparable companies lined up, the next step is to select the right multiples. These multiples are used to evaluate whether a stock is over or underpriced. Common multiples include:
- Price-to-earnings (P/E) ratio: This is the most popular multiple and compares a company’s share price to its earnings per share (EPS). If a company has a lower P/E ratio than its peers, it could be undervalued.
- Price-to-sales (P/S) ratio: This compares the company’s market cap to its revenue. It’s useful for companies that don’t yet have consistent profits.
- Price-to-book (P/B) ratio: This compares the company’s market price to its book value. It’s especially relevant for companies with significant assets like banks or real estate firms.
Choosing the right multiple depends on the industry and the company’s financial situation. For example, if you’re comparing companies in the technology sector, a P/E ratio might be more meaningful than a P/B ratio. Understanding the business and its industry is key here.
Step 3: Calculate and compare the ratios
Now that you’ve selected your multiples, it’s time to apply them to the companies in your peer group, including the one you are evaluating. For example, if the average P/E ratio of your peers is 12, and your company’s P/E ratio is 10, this might suggest that your company is undervalued.
But don’t just compare the numbers at face value. Look at the context behind the ratios. For instance, a low P/E ratio might mean that the market expects lower future growth for a company. Or, it could indicate that the stock is priced low compared to its earnings potential, which could make it a good buying opportunity.
It’s important to consider the differences between companies in your peer group. Even small variations in size, growth prospects, or profitability can affect the valuation ratios. For example, a company with higher growth prospects might trade at a higher multiple than its peers.
Step 4: Interpret the results
After calculating and comparing the ratios, you’ll have a clearer idea of how the company stacks up against its competitors. Is it undervalued or overvalued? Here are a few ways to interpret the results:
- Undervalued: If your company’s multiples are lower than its peers and it operates in a similar market, it could be undervalued. This might suggest that the stock is a good investment opportunity.
- Overvalued: If the company’s multiples are significantly higher than its peers, the stock might be overvalued. In this case, you may want to proceed with caution, as the market might be overestimating the company’s potential.
- In line with peers: If the company’s multiples are close to the industry average, it could mean the stock is fairly valued. In this case, the company might be performing well, but it may not offer any immediate price advantage.
Keep in mind that relative valuation is just one tool in your investing toolkit. It provides helpful context, but it’s important to combine it with other approaches like fundamental analysis, industry trends, and future growth projections.
Conclusion
Performing relative valuation can give you a valuable perspective on how a company compares to its peers. But remember, this approach has its limits. Market conditions change, and industries can fluctuate. One company may trade at a lower multiple due to temporary issues or market sentiment, which might not reflect its true potential.