Relative Valuation Model

A relative valuation model is a business valuation method that compares a company's value to that of its competitors or industry peers to assess the firm's financial worth. Relative valuation models are an alternative to absolute value models, which try to determine a company's intrinsic worth based on its estimated future free cash flows discounted to their present value, without any reference to another company or industry average. Like absolute value models, investors may use relative valuation models when determining whether a company's stock is a good buy.

Relative valuation uses multiples, averages, ratios and benchmarks to determine a firm's value. A benchmark may be selected by finding an industrywide average, and that average is then used to determine relative value.

There are many different types of relative valuation ratios, such as price to free cash flow, enterprise value (EV), operating margin, price to cash flow for real estate and price-to-sales (P/S) for retail.

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is calculated by dividing stock price by earnings per share (EPS), and is expressed as a company's share price as a multiple of its earnings. A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued. Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued. This framework can be carried out with any multiple of price to gauge relative market value. Therefore, if the average P/E for an industry is 10x and a particular company in that industry is trading at 5x earnings, it is relatively undervalued to its peers.

An absolute measure, on the other hand, makes no external reference to a benchmark or average. A company's market capitalization, which is the aggregate market value of all of its outstanding shares, is expressed as a plain dollar amount and tells you little about its relative value. Of course, with enough absolute valuation measures in hand across several firms, relative inferences can be drawn.

In addition to providing a gauge for relative value, the P/E ratio allows analysts to back into the price that a stock should be trading at based on its peers. For example, if the average P/E for the specialty retail industry is 20x, it means the average price of stock from a company in the industry trades at 20 times its EPS.

Assume Company A trades for $50 in the market and has an EPS of $2. The P/E ratio is calculated by dividing $50 by $2, which is 25x. This is higher than the industry average of 20x, which means Company A is overvalued. If Company A were trading at 20 times its EPS, the industry average, it would be trading at a price of $40, which is the relative value. In other words, based on the industry average, Company A is trading at a price that is $10 higher than it should be, representing an opportunity to sell.

Because of the importance of developing an accurate benchmark or industry average, it is important to only compare companies in the same industry and market capitalization when calculating relative values.