Relative Valuation: How to Value Other Stocks

Relative valuation, also referred to as comparable valuation, is a very useful and effective tool in valuing an asset. Relative valuation involves the use of similar, comparable assets in valuing another asset. (So you've finally decided to start investing. But what should you put in your portfolio? Find out here. Check out How to Pick a Stock.)

In the real estate market, relative valuation forms the framework for valuing a piece of real estate. Anyone who has ever bought, sold or had a reappraisal has seen this process at work. Anytime real estate is valued, the valuation process always integrates the value of other nearby properties that have been sold. From that starting point, the subject property is tweaked to account for any difference before arriving at a final valuation.

There's an old business adage that says an asset is only worth what the next guy is willing to pay for it. The painful truth of that reality hits home during economic meltdowns when sellers of real estate get offers that are significantly below what their homes were originally being valued at. The effectiveness of comparable valuation is that the process specifically relies on the value of other assets that have been bought or sold.

A similar and effective approach can be utilized with respect to stocks. A stock is a share in a business and the fundamentals of the underlying business can be used to determine the value of similar stocks.

Some of the most common and useful metrics to utilize in relative valuation include:

• price to earnings ratio
• return on equity
• operating margin
• enterprise value
• price to free cash flow

Since no two assets are exactly the same, any relative valuation attempt should incorporate differences accordingly. But first and foremost, you can't begin to apply relative valuation effectively if you are dealing with apples and oranges. For example, relative valuation may not be a good idea to use between McDonald's (NYSE:MCD) and Darden (NYSE:DRI). While both are restaurant companies, McDonald's is a fast food concept while Darden operates more formal sit-down concepts. Both are involved in the food business, but they offer a different concept at different price points. As such, comparing margins or another ratio would be ineffective since the business model is different.

The first step in ensuring an effective relative valuation is to make sure the two businesses are as similar as possible. (We look at three widely used valuation methods and figure out how companies justify spending. See An Introduction to Corporate Valuation Methods.)

Visa (NYSE:V) and MasterCard (NYSE:MA) are the two most well known branded credit card names in the world. Since both operate similar business models, a relative valuation for both would be an effective exercise.

Looking at both companies in the summer of 2011, Visa shares trade for $85 while MasterCard shares fetch $304. Visa has a market cap of over $60 billion while MasterCard has a market cap of $38 billion. On their own, those numbers don't tell us much except that Visa is a bigger company than MasterCard. Here are the following relative valuation metrics:

Numbers are rounded for simplicity, and all data is pulled from the most recent fiscal year numbers. Someone comparing the P/E ratios of Visa and MasterCard may conclude that Visa is a better value because of a lower P/E. However, relatively comparing various other metrics may suggest otherwise. Despite a lower operating margin, MasterCard has a significantly higher return on equity on an unlevered balance sheet. Also relative to its market cap, MA churns more cash flow per share than Visa. If MasterCard can continue pulling in the free cash flow at similar levels, then it's clearly creating more value from shareholders.

While investors often rely on market cap to determine ratios, enterprise value may be a more effective tool.

Simply defined: Enterprise Value = Market Cap + Debt - Cash

A company with loads of debt relative to cash will have an EV that is significantly higher than its market cap. That's important because a company with a market cap of a $1,000 and a profit of $100 will have a P/E of 10. If that company has $500 in net debt on the balance sheet, its EV is $1500 and its debt-adjusted P/E, or EV/E, is 15. We are looking at enterprise values to earnings here for simplicity. Normally enterprise value should be compared to EBITDA.

Another useful metric in relative valuation, return on equity, increases as a company takes on more debt. Without looking at the balance sheet an investor may conclude that company A with an ROE of 30% is more attractive than company B with an ROE of 20%. But if company A has a debt to equity ratio of two while company A is debt-free, the 20% unlevered return on equity may be much more attractive.

What the comprehensive relative valuation process ultimately does is help prevent investors from anchoring their decisions based on one or two variables. While value investors love to buy stocks with low P/E ratios, that alone may not be effective. Consider Chipotle Mexican Grill (NYSE: CMG). Even during the recession, shares were trading for around 25 times earnings when other restaurants were trading of 10-15 times earnings. But further comparison provided justification for Chipotle's P/E ratio: its margins were higher and it was growing its profits by leaps and bounds while the balance sheet remained healthy. Chipotle shares soared nearly 200% in the two years following the Great Recession.

Like any valuation tool, relative valuation has its limitations. The biggest limitation is the assumption that the market has valued the business correctly. If both Visa and MasterCard are trading at nosebleed levels, it may not matter that one has a lower P/E or better return on equity. During the Internet bubble, investing in a dot-com because its P/E was 60 versus an industry average of 90 turned out to be a painful mistake.

Second, all valuation metrics are based on past performance. Future performance drives stock prices and relative valuation does not account for growth.

Finally and most important, relative valuation is no assurance that the "cheaper" company will outperform its peer.

Like other valuation techniques, relative valuation has its benefits and limitations. The key is to focus on the metrics that matter most and understand what they convey. But in spite of those limitations, relative valuation is a very important tool used by many market professionals and analysts alike. (These five qualitative measures allow investors to draw conclusions about a corporation that are not apparent on the balance sheet. Refer to Using Porter's 5 Forces to Analyze Stocks.)