The Definition and Pros and Cons of Relative Valuation

DCF(Discounted Cash Flow) model is a valuation method that uses future cash flows from the business, its risk and growth rate. Meanwhile, relative valuation is a method of assessing the value of a target company with the market price of comparable companies.

 

Definition

Relative valuation is a way of indirectly estimating or judging the price of a target company using the market data of the peer group.

Here, estimating means to calculate a value that has not yet been formed on the market, while judging means to see whether the current market prices are low, high, or appropriate.

 

In relative valuation, you use the multiples of the peer group to value a target company. The numerator is either stock price or enterprise value, and the denominator is a financial indicator such as profit, book value, or sales.

 

 

Compared to DCF, relative valuation is more straightforward and intuitive, but you could misuse that much. There are two main factors to consider when using relative valuation.

  • One is that you should extract the numerator and the denominator of the multiples consistently from all the comparable companies. For example, suppose you use the stock price for the previous day for one company and the average price over the past month for another. In that case, the multiples calculation criteria between the two companies are different in the denominator. Similarly, when using EPS in the numerator, if you use the previous year’s profit for one company and the next year’s expected one for another, then a different criterion is applied to the multiples between the two.
  • Another is to find comparable companies to the target company you want to assess. This is a more difficult problem than the above one. Usually, one of the ways is to select companies in the same industry as the target company. However, they may have different cash flow composition, potential growth rates, and risks. Furthermore, when you select firms with these different attributes, how to adjust the calculated multiples becomes another concern.

 

The pros and cons of Relative Valuation Method

Despite the tricky parts described above, relative valuation is widely used by analysts and M&A experts. The reasons are as follows:

  • First, relative valuation does not require as many assumptions as DCF and could be calculated quickly. The DCF method using FCF usually have to go through a complicated process to estimate the free cash flows over the next five years. On the other hand, relative valuation only requires the recent stock price and the financial figures of the past or the following year.
  • Second, because the calculation method is simple, it is easy to explain to customers or clients. Relative valuation is calculated mainly in two stages. 1) Calculate the financial figures of the target company and then 2) calculate the multiples of the peer group. These processes are simple and easy to understand, and because they are intuitive, it is easy to grasp what conclusions are drawn.
  • Lastly, relative valuation reflects the current market prices and environments. For some stakeholders, market prices may be more important than intrinsic value. For example, for fund managers trading listed stocks or analysts doing market research, relative valuation could be more useful because the market prices determine their performance. 

 

However, these advantages are also weaknesses of it as follows:

 

  • First, the comparable companies picked up to value the target one may have different risk, growth rate, and cash flow attributes even if they belong to the same industry. As a result, you might get the target company’s value with the wrong-selected peer group.
  • Second, it is easy for valuators to subjectively or biasedly manipulate the results. The DCF’s assumptions come out apparently on the reports, while the relative valuation assumptions are easy to be hidden behind them.
  • Finally, reflecting only the stock market atmosphere rather than the intrinsic value could be a weakness. If the market overestimates or underestimates a specific industry or company, the target company’s value could be so.

 

 

The Kinds of Multiples

Relative valuation is the concept of multiples, ‘how many times the stock price is formed compared to a specific financial figure’. Companies can ve valued with this multiples. Since it is meaningless to compare one company’s stock price to another itself, standardisation of price is necessary. Multiples are appropriate for this aspect. Multiples can be classified into four broad categories, depending on the type of financial indicator that goes to the numerator.

 

 

  1. Earnings multiples

This is the company’s value expressed as multiples of its earnings. It means ‘how much investors are paying for the company’s earnings of £1’. P/E and EV/EBITDA are representative earnings multiples.

 

PE Ratio = PER = Share price / Earnings per share = Price / EPS

 

PER is the share price divided by the EPS. You can include or exclude non-recurring gains or losses in it and can use the previous year’s or the following year’s one. However, you should apply the same criteria to all comparable companies for consistency.

 

EBITDA multiples = Enterprise value / Earnings before interest tax depreciation and amortisation = EV/EBITDA

EV = Market value of equity and debt minus cash
EBITDA = Operating income before tax added with tangible and intangible depreciation

 

EV/EBITDA is a company’s operating value (EV) divided by EBITDA, which is especially useful for M&A valuation.

 

 

  1. Book value multiples

This is the value of a company described as multiples of the net asset value. You can value a target company by seeing how many times the stock price is formed compared to the book value. PBR is a representative book value multiples.

 

Book Value ratio = PBR = Share price / Book value per share = Price / BPS

 

PBR is the share price divided by the BPS. Earnings used in PER tend to fluctuate according to accounting standards, but book value is less affected by them.

 

 

  1. Revenue multiples

This is the company’s value expressed as multiples of sales. You can see how many times the equity value or the firm is valued compared to sales.

 

Price Sales ratio = PSR = Market value of equity / Sales

 

PSR is the market cap of a company divided by sales. Since sales are less affected by accounting standards than earnings or book value, it may be easier to compare among companies with different accounting standards. Besides, its advantage is that you can apply it to early-stage or growing companies that have a deficit or negative net asset.

 

Enterprise Value Sales ratio = EVSR = EV / Sales

 

EVSR is EV divided by sales. PSR is used to assess the equity value, while EVSR is for enterprise value.

 

 

  1. Sector-specific multiples

Earnings, net asset value, and sales revenue are all financial indicators that can be applied to any company, whereas there are multiples that can only come out from specific businesses.

 

Sector-specific multiples = EV / Number of users (or members)

 

Sector-specific multiples are the firm value divided by the number of users or members. The type of users may vary depending on the business. For example, they can be the number of subscribers for an SNS business, the number of visitors to a website, or the number of users on a game site. When financial indicators are not available, these sector-specific numbers may have meaning. That is especially true if sales revenue or profits have not yet occurred.

Nonetheless, its drawback could be to overvalue or undervalue the business. In addition, it could be unreasonable to link these multiples to the intrinsic value. For example, not all visitors to a site contribute to sales or profit.

 

 

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