Types and uses of the Relative Valuation Multiples
The relative valuation model is a method of indirectly estimating or judging the market value of a target company by referring to the market price of comparable companies that have similar properties to the target company. The numerator’s market price in the formula below can be the comparable companies’ stock price or enterprise value. The denominator’s financial indicators can be their profit, book value, or sales.
‘Estimating a target company’s market value’ mentioned above means’ predicting the target company’s market price.’ Also, ‘judging a target company’s market value’ means ‘determining whether its current market price is high, low, or appropriate.’
The relative valuation model is more straightforward and intuitive than the DCF model, but there are two things to keep in mind.
First, when calculating valuation multiples, the types of input used for the numerator and denominator must be consistent. For example, suppose one company uses the most recent stock price for the denominator, and another company uses the average stock price for the last month. In that case, the multiple calculation criteria between the two companies are different. Similarly, when using EPS for the numerator, if you use the previous year’s EPS for one company and the next year’s estimate for another, you’re applying different criteria for the two companies.
Second is to select comparable companies correctly. The easiest way you can usually do is choosing them in the same industry as the target company. However, even companies within the same industry may have different business composition. As a result, the cash flows’ features, growth rate, or risks may differ. Finding comparable companies for relative valuation model requires much effort.
Pros and cons of the relative valuation model
Analysts and M&A experts generally use the relative valuation model. The reason for this is as follows;
First, the relative valuation model does not require as many assumptions as the DCF model does, and it can be calculated quickly. Using the DCF model requires a rather complicated task from you to estimate future free cash flow. On the other hand, the relative valuation model needs only the valuation multiples of the peer group and the target company’s financial indicators so that you can do it relatively quickly.
Second, its intuitive and straightforward calculation method makes it easy to explain to customers or clients. In the relative valuation model, you can reach a conclusion by following two necessary steps. You first analyse the target company, calculate its financial indicators, and then find the comparable companies, calculate their valuation multiples. It is easy to grasp how the conclusion has been drawn because those processes are simple, easy to understand, and intuitive.
Finally, the relative valuation model reflects the current market atmosphere and price. The current market price should be more important rather than its cash flows’ intrinsic value for some stakeholders, such as fund managers or equity research analysts. Since their performance can be judged by the market index or price, the relative valuation model should be more useful.
However, those advantages also become weaknesses of the relative valuation model.
First, comparable companies selected to value a target company may have different businesses in some ways, even if they are within the same industry. Accordingly, their business risk or growth rate may differ from the target, which leads you to misvalue it with the wrong chosen comparable companies’ valuation multiples.
Second, there are chances that evaluators may manipulate the results by a subjective or biased selection of comparable companies. They may intentionally tailor the outcome by including some companies in the peer group or excluding others.
Finally, reflecting the stock market’s mood rather than the intrinsic value of cash flows may be a weakness. If a specific industry or company is overvalued or undervalued in the market, the target company’s value will also be misvalued.
Types of valuation multiples
Valuation multiples mean ‘how many times the market price is higher compared to a specific financial indicator’. Usually, when comparing valuation multiples across stocks within the same industry, we might think stocks with higher valuation multiples are more overvalued. We can classify valuation multiples according to the types of financial indicators of the numerator. Among them, practitioners often use three types of valuation multiples.
1) Earnings multiples
Earnings multiples are a company’s value expressed as a multiple of its profit. It means ‘how much investors pay for the profit of $1 a company generates’ or ‘how many times the company’s market price is higher than the profit’. Representative earnings multiples are PER (Price-to-Earnings Ratio) and EV/EBITDA.
PER = Stock price / EPS
PER is the share price divided by EPS (Earnings Per Share). That tells you the amount investors pay for the net income of $1. Assume that firm A and B have a PER of 5 and 20, respectively. That means that investors pay $5 for the $1 net profit of firm A and $20 for firm B. In a simple comparison, we can say that firm B is overvalued because investors pay more for firm B’s net profit.
EV/EBITDA = EV / EBITDA
EV/EBITDA is EV(Enterprise Value) divided by EBITDA. Equity value is the value of stockholders. EV is the total value of stockholders and debtholders. EBITDA is EBIT (we usually replace it with operating income.) plus tangible and intangible depreciation expenses. EV/EBITDA is a handy indicator especially for M&A valuation.
2) Book-value multiples
Book-value multiples are a company’s value expressed as a multiple of its net asset. PBR (Price-to-Book Ratio) is typical for book-value multiples. It means how many times the market value of equity capital is higher than the book value.
PBR = Share price / BPS
PBR is the share price divided by BPS (book value per share). The higher the PBR, the higher the market value of the company’s net asset. For example, assume that Firms A and B have net assets of $100, and PBR of 0.5 and 2, respectively. In this case, firm A’s market cap is $50, and B’s is $200. Investors value B’s book-value higher than A’s. EPS might fluctuate depending on the accounting method, but BPS is relatively robust on it.
3) Sales multiples
Sales multiples are a company’s value expressed as a multiple of its sales. Representative sales multiples are PSR (Price-to-Sales Ratio) and EV/Sales. It means how many times a stock price is higher compared to sales.
PSR = Market value of equity / Sales revenue
PSR is a company’s market cap divided by its sales. It means how many times the stock price is valued compared to sales. Since sales are less affected by the accounting method than EPS or BPS, it may be better to compare companies with different accounting standards. You can also apply it to companies experiencing deficits or undermined capital, such as early or declining companies.
EV/Sales = EV / Sales revenue
EV/Sales is EV divided by sales. PSR is used to evaluate the stock value, and EVSR is used to assess EV.