What Is Relative Valuation?

Determining the valuation of a company is essential before investing. It will help you unearth undervalued companies and avoid overvalued ones. Among the various approaches for finding out the value of a company, there is one that is highly popular: relative valuation. 

In this article, we are going to delve into relative valuation models and understand this unique approach with an example. Additionally, we will also examine the various types of relative valuation often used by successful investors.

Relative Valuation Meaning

Relative valuation is an approach that involves determining the value of a company by comparing it with other highly similar companies. This particular approach to determining a company’s valuation is based on the principle that similar assets are priced similarly in the market. 

Most relative valuation models use a wide range of financial metrics to compare companies with one another. Some of the key ratios that are used include price-to-earnings (P/E) ratio, price-to-book value (P/B) ratio, price-to-sales (P/S) ratio, price-to-cash flow (PCF) ratio, price/earnings-to-growth (PEG) ratio, enterprise value (EV), enterprise value to revenue (EV/Revenue) ratio, and enterprise value to EBITDA (EV/EBITDA) ratio.

One of the main advantages of relative valuation models is their simplicity and ease of use. Investors often find this approach quicker to perform than other more complex valuation methods like the Discounted Cash Flow (DCF) method. This makes relative valuation a popular choice among analysts and investors for swift initial assessments.  

Relative Valuation Model Example

Here is a hypothetical relative valuation model example to help you understand how this approach actually works. 

Assume you are trying to value a two-wheeler manufacturing company called ABC Limited. The first step is to identify comparable companies that are in the same business and with similar growth rates. You unearth three such companies – DEF Limited, LMN Limited, and XYZ Limited. 

Now that the comparable companies are identified, you set out to gather key financial metrics. For this particular relative valuation model example, we will take two metrics: price-to-earnings (P/E) ratio and enterprise value-to-EBITDA (EV/EBITDA) ratio.

Here is a quick overview of the key financial metrics of the companies in question. 

Using the average P/E ratio and EV/EBITDA ratio, we can estimate the valuation of ABC Limited. If the total annual earnings of ABC Limited is ₹10 crore and EBITDA is ₹15 crore, the company’s estimated valuation will be: 

Valuation based on P/E Ratio: ₹10 crore x 25 = ₹250 crore

Valuation based on EV/EBITDA: ₹15 crore x 15 = ₹225 crore    

Furthermore, we can also determine whether the company is undervalued or overvalued by comparing its P/E ratio with the industry average. 

For instance, if the P/E ratio of ABC Limited is 20 and the industry average is 25, we can conclude that the company is undervalued and presents an attractive opportunity for long-term investors. 

What are the Different Types of Relative Valuation?  

Now that you are aware of the meaning of relative valuation and how it is used to determine the value of a company, let us look at the different variants of this approach. 

• Comparable Company Analysis 

One of the most widely used types of relative valuation, comparable company analysis is an approach that involves comparing a company with highly similar peers. The relative valuation model example that we saw above is a classic example of the comparable company analysis approach. 

Since this approach uses real-time market data, it often reflects the market sentiment and investor expectations more efficiently. Furthermore, it is relatively simple to understand and easy to perform. 

However, the comparable company analysis method is not without its limitations. The method assumes that the market always prices the comparable companies efficiently, which may not be the case. Also, the approach does not account for company-specific strengths and risks or the future growth potential.        

• Precedent Transaction Analysis 

The precedent transaction analysis is the other type of relative valuation method that is used by investors and large financial institutions. This approach involves analysing recent mergers and acquisitions of similar-sized companies to determine valuation.

One of the major drawbacks of this relative valuation model is that the transaction data of mergers and acquisitions are not easy to obtain. Furthermore, there is always the risk of the information becoming out of date and not accurately reflecting the current market conditions.     

How is Relative Valuation Different From Intrinsic Value? 

Intrinsic value and relative valuation are two different methods of determining a company’s valuation. While relative models seek to compute valuation by comparing a company with its peers, intrinsic value seeks to determine a company’s worth based on its expected future cash flows, growth potential, and risk factors.

The other major difference between the two approaches is the level of complexity. Intrinsic value is a significantly more complex and time-consuming approach compared to relative valuation.   

Conclusion 

Relative valuation models are highly useful tools that can help you quickly determine a company’s worth. With this approach, you can identify potential investment opportunities easily without exhausting a lot of your time. 

That said, relative valuation is only ideal for preliminary analysis. If you wish to perform an in-depth fundamental analysis of a company, it is advisable to use other valuation models like the Discounted Cash Flow (DCF) method and intrinsic value analysis. This way, you can make informed decisions and become more successful at long-term investing.      

FAQs