What’s a Relative Valuation Model?
A relative valuation model is a business valuation method that assesses a company’s value by comparing it to that of its competitors or industry peers. Unlike absolute valuation models, which determine a firm’s intrinsic worth based purely on its projected future free cash flows discounted to the present value, relative valuation methods derive value by benchmark comparisons. Investors employ relative valuation models to decide whether a company’s stock is a good buy.
Key Takeaways
- A relative valuation model juxtaposes a firm’s value with that of its competitors to ascertain its financial worth.
- One of the most renowned relative valuation multiples is the price-to-earnings (P/E) ratio.
- Distinct from absolute valuation models, relative valuation models reference other companies or industry benchmarks.
- Relative valuation models are utilized to evaluate a company’s stock prices in comparison to its market counterparts.
Various Types of Relative Valuation Models
Numerous relative valuation ratios exist, 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.
Among these, the [price-to-earnings (P/E)] ratio stands out. This multiple divides the stock price by earnings per share (EPS), representing a company’s share price as a multiple of its earnings. Companies with high P/E ratios are deemed overvalued, trading at a higher price per dollar of earnings. Conversely, low P/E ratios signal undervaluation. If an industry’s average P/E is 10x, a company trading at 5x earnings is relatively undervalued compared to its peers.
Relative Valuation Model vs. Absolute Valuation Model
Relative valuation leverages multiples, averages, ratios, and benchmarks to evaluate a firm’s worth. Benchmarks derive from industry-wide averages to establish relative values. Absolute valuation, devoid of external references, gauges value solely based on intrinsic financial health. However, through extensive absolute valuations, relative valuation inferences can be extrapolated.
Special Considerations
Estimating Stock’s Relative Value
The P/E ratio not only guides relative value but also helps analysts deduce the price at which a stock should trade based on industry benchmarks. For example, if the specialty retail industry average P/E is 20x, a company’s share price should ideally be 20 times its EPS.
Consider Company A trading at $50 with an EPS of $2. Its P/E ratio is calculated as 25x ($50/$2), higher than the industry average of 20x, indicating overvaluation. Adjusting for the industry average P/E would suggest Company A should trade at $40, offering an indicator to sell. Thus, a nuanced and exclusive industry comparison is pivotal for accurate relative values.
Related Terms: absolute valuation, market capitalization, enterprise value.
References
- AnalystPrep. “Valuation Models”.
- Aswath Damodaran, Stern School of Business at New York University. “Relative Valuation”. Page 4.
- OpenStax, Rice University. “Principles of Finance: 11.1 Multiple Approaches to Stock Valuation”.
- Aswath Damodaran, Stern School of Business at New York University. “Relative Valuation (Pricing)”. Page 14.
- Aswath Damodaran, Stern School of Business at New York University. “Chapter 4: Relative Valuation”.
