Relative Valuation
Relative Valuation
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What is it?: The value of any asset can be estimated by
looking at how the market prices “similar” or ‘comparable”
assets.
Philosophical Basis: The intrinsic value of an asset is
impossible (or close to impossible) to estimate. The value of
an asset is whatever the market is willing to pay for it (based
upon its characteristics)
Problem: “A biased analyst who is allowed to choose the
multiple on which the valuation is based and to pick the
comparable firms can essentially ensure that almost any
value can be justified.” – Aswath Damodaran
Relative Valuation (cont’d)
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Information Needed: To do a relative valuation, you need
 an identical asset, or a group of comparable or similar
assets
 a standardized measure of value (in equity, this is
obtained by dividing the price by a common variable, such
as earnings or book value)
 and if the assets are not perfectly comparable, variables
to control for the differences
Market Inefficiency: Pricing errors made across similar or
comparable assets are easier to spot, easier to exploit and
are much more quickly corrected.
Standardizing Value
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Prices can be standardized using a common variable such as
earnings, cashflows, book value or revenues.
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Earnings Multiples
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Book Value Multiples
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Price/Book Value(of Equity) (PBV)
Value/ Book Value of Assets
Value/Replacement Cost (Tobin’s Q)
Revenues
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Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
Value/EBIT
Value/EBITDA
Value/Cash Flow
Price/Sales per Share (PS)
Value/Sales
Industry Specific Variable (Price/kwh, Price per ton of steel ....)
SOURCE: Pablo Fernandez, Valuation Methods and Shareholder Value Creation
SOURCE: Pablo Fernandez, Valuation Methods and Shareholder Value Creation
Understanding Multiples
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Define the multiple
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Describe the multiple
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Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on whether it
is too high or low.
Analyze the multiple
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In use, the same multiple can be defined in different ways by different users.
When comparing and using multiples, estimated by someone else, it is critical
that we understand how the multiples have been estimated
It is critical that we understand the fundamentals that drive each multiple, and
the nature of the relationship between the multiple and each variable.
Apply the multiple
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Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.
Definitional Tests
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Is the multiple consistently defined?
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Both the value (the numerator) and the standardizing variable (
the denominator) should be to the same claimholders in the firm.
In other words, the value of equity should be divided by equity
earnings or equity book value, and firm value should be divided
by firm earnings or book value.
Is the multiple uniformly estimated?
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The variables used in defining the multiple should be estimated
uniformly across assets in the “comparable firm” list.
If earnings-based multiples are used, the accounting rules to
measure earnings should be applied consistently across assets. The
same rule applies with book-value based multiples.
Descriptive Tests
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What is the average and standard deviation for this multiple,
across the universe (market)?
What is the median for this multiple?
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How large are the outliers to the distribution, and how do we
deal with the outliers?
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The median for this multiple is often a more reliable comparison point.
Throwing out the outliers may seem like an obvious solution, but if the
outliers all lie on one side of the distribution (they usually are large
positive numbers), this can lead to a biased estimate.
Are there cases where the multiple cannot be estimated? Will
ignoring these cases lead to a biased estimate of the multiple?
How has this multiple changed over time?
Analytical Tests
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What are the fundamentals that determine and drive these
multiples?
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Embedded in every multiple are all of the variables that drive every
discounted cash flow valuation - growth, risk and cash flow patterns.
In fact, using a simple discounted cash flow model and basic algebra
should yield the fundamentals that drive a multiple
How do changes in these fundamentals change the multiple?
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The relationship between a fundamental (like growth) and a multiple
(such as PE) is seldom linear. For example, if firm A has twice the
growth rate of firm B, it will generally not trade at twice its PE ratio
It is impossible to properly compare firms on a multiple, if we do
not know the nature of the relationship between fundamentals
and the multiple.
Application Tests
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Given the firm that we are valuing, what is a
“comparable” firm?
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It is impossible to find an exactly identical firm to the one you
are valuing.
While traditional analysis is built on the premise that firms in
the same sector are comparable firms, valuation theory would
suggest that a comparable firm is one which is similar to the
one being analyzed in terms of fundamentals.
Damodaran says, “There is no reason why a firm cannot be
compared with another firm in a very different business, if the
two firms have the same risk, growth and cash flow
characteristics.” This is not necessarily the case. Legal
requirements may dictate limits in some applications but, more
importantly, the underlying economics must make sense.
Criteria to Identify Comparable Firms
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Capital Structure
Credit Status
Depth of Management
Personnel Experience
Nature of Competition
Maturity of the Business
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SOURCE: Pratt et al, Valuing A Business (4th edition)
Products
Markets
Management
Earnings
Dividend-paying
Capacity
Book Value
Position in Industry
Choosing Comparable Firms (1)
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In valuing a manufacturer of electronic control
equipment for the forest products industry, we found
plenty of manufacturers of electronic control
equipment but none for whom the forest products
industry was a significant part of their market.
What to do?
For guideline companies, we selected manufacturers
of other types of industrial equipment and supplies
which sold to the forest products and related cyclical
industries. We decided the markets served were
more of an economic driving force than the physical
nature of the products produced.
Adapted from: Pratt et al, Valuing A Business (4th edition)
Choosing Comparable Firms (2)
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At the valuation date in the estate of Mark Gallo, there
was only one publicly traded wine company stock, a
tiny midget compared with the huge Gallo and, for
other reasons as well, not a good guideline company.
What to do?
Experts for the taxpayer and for the IRS agreed it was
appropriate to use guideline companies which were
distillers, brewers, soft drink bottlers, and food
companies with strong brand recognitions and which
were subject to seasonal crop conditions and grower
contracts.
Adapted from: Pratt et al, Valuing A Business (4th edition)
Advantages of Relative Valuation
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Relative valuation is much more likely to reflect
market perceptions and moods than discounted
cash flow valuation. This can be an advantage
when it is important that the price reflect these
perceptions as is the case when
 the objective is to sell a security at that price
today (as in the case of an IPO)
 investing on “momentum” based strategies
With relative valuation, there will always be a
significant proportion of securities that are under
valued and over valued.
Advantages of Relative Valuation (cont’d)
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Since portfolio managers are judged based upon
how they perform on a relative basis (to the market
and other money managers), relative valuation is
more tailored to their needs (but remember the
“biased analyst” warning cited earlier).
Relative valuation generally requires less
information than discounted cash flow valuation
(especially when multiples are used as screens)
Disadvantages of Relative Valuation
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A portfolio that is composed of stocks which are
under valued on a relative basis may still be
overvalued, even if the analysts’ judgments are
right. It is just less overvalued than other securities
in the market.
Relative valuation is built on the assumption that
markets are correct in the aggregate, but make
mistakes on individual securities. To the degree that
markets can be over or under valued in the
aggregate, relative valuation will fail
Disadvantages of Relative Valuation (cont’d)
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Relative valuation may require less information in
the way in which most analysts and portfolio
managers use it. However, this is because implicit
assumptions are made about other variables (that
would have been required in a discounted cash flow
valuation). To the extent that these implicit
assumptions are wrong the relative valuation will
also be wrong.
When relative valuation works best…
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This approach is easiest to use when
 there are a large number of assets comparable to
the one being valued
 the appropriate multiple for the potential guideline
companies does not show wide dispersion of
data.
 these assets are priced in a market
 there exists some common variable that can be
used to standardize the price
When relative valuation works best (cont’d)
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This approach tends to work best for investors who
 have relatively short time horizons
 are judged based upon a relative benchmark (the
market, other portfolio managers following the
same investment style etc.)
 can take actions that can take advantage of the
relative mispricing; for instance, a hedge fund
can buy the under valued and sell the over
valued assets
PE Ratio and Fundamentals
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Other things held equal, higher growth firms will have
higher PE ratios than lower growth firms.
Other things held equal, higher risk firms will have lower
PE ratios than lower risk firms
Other things held equal, firms with lower reinvestment
needs will have higher PE ratios than firms with higher
reinvestment rates.
Of course, other things are difficult to hold equal since high
growth firms, tend to have risk and high reinvestment rats.
PE Ratio: Understanding the Fundamentals
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To understand the fundamentals, start with a basic
equity discounted cash flow model.
With the dividend discount model,
P0 
DPS1
r  gn
Dividing both sides by the earnings per share,
P0
Payout Ratio * (1  g n )
 PE =
EPS0
r-gn
If this had been a FCFE Model,
P0 
FCFE1
r  gn
P0
(FCFE/Earnings) * (1  g n )
 PE =
EPS0
r-g n
Relative PE: Definition
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The relative PE ratio of a firm is the ratio of the PE of the firm to
the PE of the market.
Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing
earnings or forward earnings, consistency requires that it be
estimated using the same measure of earnings for both the firm
and the market.
Relative PE ratios are usually compared over time. Thus, a firm or
sector which has historically traded at half the market PE (Relative
PE = 0.5) is considered over valued if it is trading at a relative PE
of 0.7
The average relative PE is always one.
The median relative PE is much lower, since PE ratios are skewed
towards higher values. Thus, more companies trade at PE ratios
less than the market PE and have relative PE ratios less than one.
Relative PE: Cross Sectional Distribution
Relative PE: Summary of Determinants
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The relative PE ratio of a firm is determined by two variables. In
particular, it will
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increase as the firm’s growth rate relative to the market increases.
The rate of change in the relative PE will itself be a function of the
market growth rate, with much greater changes when the market
growth rate is higher. In other words, a firm or sector with a growth
rate twice that of the market will have a much higher relative PE when
the market growth rate is 10% than when it is 5%.
decrease as the firm’s risk relative to the market increases. The
extent of the decrease depends upon how long the firm is expected to
stay at this level of relative risk. If the different is permanent, the
effect is much greater.
Relative PE ratios seem to be unaffected by the level of rates,
which might give them a decided advantage over PE ratios.
Consider this…
You have valued Earthlink Networks, an internet service
provider, relative to other internet companies using Price/Sales
ratios and find it to be under valued almost 50% .When you
value it relative to the market, using the market regression, you
find it to be overvalued by almost 50%. How would you
reconcile the two findings?
 One of the two valuations must be wrong. A stock cannot be
under and over valued at the same time.
 It is possible that both valuations are right.
What has to be true about valuations in the sector for the second
statement to be true?
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