6.2 Relative valuation methods

Relative valuation methods compare a company's financial metrics to similar firms in the industry. These techniques, like P/E and EV/EBITDA ratios, offer quick insights into a stock's value by leveraging market data and investor sentiment.

While relative valuation is simple and widely used, it has limitations. The approach assumes market efficiency and can perpetuate mispricing. Analysts must carefully select comparable companies and consider multiple metrics to arrive at a fair value estimate.

Relative Valuation Multiples

Types of Relative Valuation Multiples

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• Relative valuation multiples compare financial metrics of similar companies within an industry or sector
• Price multiples use market price per share as the numerator for equity valuation (P/E, P/B)
• Enterprise value multiples use total company value for comparing different capital structures (EV/EBITDA, EV/Sales)
• Forward-looking multiples utilize projected financial metrics
• Trailing multiples employ historical data
• Industry-specific multiples provide targeted comparisons (price-to-subscribers for telecom, price-to-rooms for hotels)

Selecting and Applying Multiples

• Multiple choice depends on industry, company-specific factors, and valuation purpose
• Price multiples work well for companies with similar capital structures
• Enterprise value multiples suit companies with varying debt levels
• Forward multiples reflect future expectations
• Trailing multiples show historical performance
• Industry-specific multiples capture unique sector characteristics (occupancy rates for hotels)

P/E and EV/EBITDA Ratios

Calculating P/E and EV/EBITDA

• P/E ratio divides stock price by earnings per share $P/E ratio = \frac{Market Price per Share}{Earnings per Share}$
• EV/EBITDA ratio divides enterprise value by EBITDA $EV/EBITDA = \frac{[Market Capitalization](https://www.fiveableKeyTerm:Market_Capitalization) + Total Debt - Cash and Cash Equivalents}{EBITDA}$
• P/E focuses on equity value
• EV/EBITDA accounts for total company value including debt

Interpreting P/E and EV/EBITDA

• High P/E suggests overvaluation or high growth expectations (Amazon's high P/E)
• Low P/E indicates undervaluation or lower growth expectations (value stocks like Ford)
• Low EV/EBITDA points to potential undervaluation (mature industries like utilities)
• High EV/EBITDA implies overvaluation or strong future performance expectations (high-growth tech companies)
• Compare ratios to industry averages, historical trends, and competitor values
• Consider growth prospects, risk profile, and industry dynamics in interpretation
• P/E useful for profitable companies, EV/EBITDA better for capital-intensive or leveraged firms

Strengths vs Weaknesses of Relative Valuation

Advantages of Relative Valuation

• Simple and easy to use for quick company comparisons
• Provides market-based perspective reflecting current investor sentiment
• Particularly useful with many comparable companies (retail sector)
• Assumes market efficiency in pricing similar assets
• Incorporates real-time market data and expectations
• Allows for industry-wide trends analysis (comparing all major banks)

Limitations of Relative Valuation

• Entire industries can be overvalued or undervalued, skewing comparisons (tech bubble of late 1990s)
• May not account for company-specific factors (growth prospects, competitive advantages)
• Choice of comparables and time periods introduces subjectivity
• Less suitable for unique or complex businesses (early-stage biotech firms)
• Can perpetuate market inefficiencies or herd behavior
• Difficult to apply in volatile markets or economic downturns

Applying Relative Valuation for Fair Value

Selecting Comparables and Multiples

• Choose comparable companies based on industry, size, growth rate, and business model
• Select relevant multiples reflecting company and industry characteristics
• Calculate chosen multiples for comparable companies
• Determine median or average values of selected multiples
• Consider using multiple valuation metrics for a comprehensive analysis (P/E, EV/EBITDA, P/B)

Estimating and Adjusting Fair Value

• Apply industry-average multiples to subject company's financial metrics
• Adjust valuation for company-specific factors (growth prospects, profit margins)
• Use weighted average of different multiples for comprehensive fair value estimate
• Compare estimated fair value to current market price
• Determine if stock is overvalued, undervalued, or fairly valued
• Conduct sensitivity analysis to account for varying assumptions (different growth rates)
• Consider qualitative factors impacting valuation (management quality, brand strength)