Relative Valuation Method: Meaning and Approach

Defining the Relative Valuation Approach 

In the previous two chapters, we studied how the Discounted Cash Flow (DCF) approach can be used to find the valuation of a company's stock. Under that approach, we dived deep into two methods of DCF, i.e., the dividend discount model and the free cash flow method. However, towards the end of the chapter, we also noted some of the key limitations of the DCF approach. An alternative approach to valuation can be relative valuation. 

Let’s understand this with an example, and you will be able to relate to it. Imagine you're at a fruit and vegetable market and deciding between two sellers selling fruits and vegetables: Seller A and Seller B. More often than not, you will compare the prices of similar fruits by Seller A and Seller B to determine which seller offers better value for money. It's not just about the absolute quality of the fruits and vegetables; it's also about the relative pricing. 

In the investing world, too, relative valuation works similarly. Instead of just analysing the individual metrics of a company, you compare those metrics to similar companies in the market to identify which offers better value for your investment.

Please note that here, the word relative is necessary. An asset may be undervalued relative to a comparable asset or group of assets, and an investor may thus expect the asset to outperform the comparable asset or assets on a relative basis. However, if the comparable asset or assets are not efficiently priced, the stock may not be undervalued. It could be either fairly valued or overvalued (on an absolute basis, i.e., with its intrinsic value).

The relative valuation is based on the principle of the law of one price, i.e., if two identical assets are similar, they should be valued similarly and thus should have the exact pricing. 

But on what metrics should an investor compare one company with another? The metrics that are used in relative comparison are:

• Price to Earnings ratio [P/E ratio]
• Price to Book ratio [P/B ratio]
• Price to Sales ratio [P/S ratio]
• Enterprise value to EBITDA ratio [EV/EBITDA ratio] 

We hope these ratios are familiar to you because each ratio's meaning, calculation, analysis, interpretation, and limitation were covered in detail in the valuation ratios chapter. That’s why, in this chapter, we will focus on how to arrive at a valuation decision using relative valuation. 

Decision-Making Using Relative Valuation

The valuation rule is simple in the case of relative valuation:

• The higher the value of a valuation ratio, the more expensive a stock is relative to another stock. 
• The lower the value of a valuation ratio, the cheaper a stock is relative to another stock. 

Thus, an investor simply has to arrange the values of the valuation ratio, compare those values with other stocks of an industry, and identify the undervalued pick priced relatively cheaper than other peers. 

Let’s do this with XYZ Ltd and its peers for the different valuation ratios we have studied.

Analysis and interpretation:

• The companies were compared based on four key valuation ratios. 
• As clearly visible, ABC Ltd. seems to be the most undervalued stock due to lower ratio values. 
• DEF Ltd seems to be the most overvalued stock due to higher ratio values. 

Does that mean an investor should invest directly in ABC Ltd? The answer is, of course, not. This brings us to the limitations of using the relative valuation method. 

Often, most investors commit the mistake of directly investing their entire capital into a relatively undervalued stock without digging much deeper into the company's fundamentals. The problem with relative valuation is:

• It does not consider the company's fundamentals. In the above example, it might be possible that DEF Ltd. has higher sales growth, better profit margins, or even sound promoters. And that’s why it is commanding a premium in the market over peers. That’s why looking at the relative valuation ratios will ignore all other factors. 
• The relative valuation approach is usually suitable for comparing companies that belong to the same industry and are identical. This is so because in such a scenario, a common set of factors will drive a company’s value, making the ratios' value comparable. Therefore, there is a very happy dependency on finding a comparable company. 

Example: There is no point in comparing the P/E ratio of a paint company with, let’s say, an auto company or an IT company. 

• Not all ratios can be applied to any industry. Specific ratios are suitable for certain industries over others. 

Example: 

• EV/EBITDA ratio is more suitable to value capital-intensive businesses.
• The P/B ratio is more suitable for valuing banks and financial institutions. 
• The valuation ratios of peers may be distorted due to some external market conditions or even short-term fluctuations. This might lead to wrong decision-making and misjudgment about the relative valuation of a stock.
• In cyclical industries, where companies' earnings fluctuate with phases of economic cycles, using a relative valuation approach during peak or trough periods may lead to inaccurate assessments of a company's value.

Therefore, even relative valuation metrics should be used carefully. 

Concluding Remarks on Different Approaches to Valuation

In all three chapters of valuation, which covered both the discounted cash flow approach and the relative approach to valuation, we saw that every approach has its own set of limitations. That’s why an investor is advised to use a combination of approaches to value a company, which will provide investors with a possible range of values for a company and have more conviction in investing in a stock. 

The advantages of combining different valuation approaches are:

• It helps investors cross-verify their analysis and build a robust analysis. 
• Using different methods, investors can better assess the risk associated with their investment decisions. 
• An investor can adapt their analysis to different economic or industry environments by employing various approaches, as each method reacts differently in different market conditions. 
• Using different valuation models helps in valuing complex business models, whose valuation using a simple approach may not yield reliable estimates.