Relative Valuation

While the focus in classrooms and academic discussions remains on discounted cash flow valuation, the reality is that most assets are valued on a relative basis. In  relative valuation, we value an asset by looking at how the market prices similar assets. Thus, when determining what to pay for a house, we look at what similar houses in the neighbor hood sold for rather than doing an intrinsic valuation. Extending this analogy to 

stocks, investors often decide whether a stock is cheap or expensive by comparing its pricing to that of similar stocks (usually in its peer group). In this section, we will consider the basis for relative valuation, waysin which it can be used and its advantages and disadvantages. Basis for approach In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable. Included in this description  are two key components of relative valuation. The first is the notion of comparable or similar assets. From a valuation standpoint, this would imply assets with similar cash flows, risk and growth potential. In practice, it is usually taken to mean other companies that are in the same business as the company being valued. The other is a standardized price. After all, the price per share of a company is in some sense arbitrary since it is a function of the number of shares outstanding; a two for one stock split would halve the price. Dividing the price or market value by some measure that is related to that value will yield a standardized price. When valuing stocks, this essentially translates into using multiples where we divide the market value by earnings, book value or revenues to arrive at an estimate of standardized value. We can then compare these numbers across companies.

The simplest and most direct applications of relative valuations are with real assets where it is easy to find similar assets or even identical ones. The asking price for a Mickey Mantle rookie baseball card or a 1965 Ford Mustang is relatively easy to estimate given that there are other Mickey Mantle cards and 1965 Ford Mustangs out there and that the prices at which they have been bought and sold can be obtained. With equity valuation, relative valuation becomes more complicated by two realities. The first is the absence of similar assets, requiring us to stretch the definition of comparable to include companiesthat are different from the one that we are valuing. After all, what company in the world is remotely similar to Microsoft or GE? The other is that different ways of standardizing prices (different multiples) can yield different values for the same
company. Harking back to our earlier discussion of discounted cash flow valuation, we argued that discounted cash flow valuation was a search (albeit unfulfilled) for intrinsic value. In relative valuation, we have given up on estimating intrinsic value and essentially put our trust in markets getting it right, at least on average.


Variations on Relative Valuation In relative valuation, the value of an asset is based upon how similar assets are priced. In practice, there are three variations on relative valuation, with the differences primarily in how we define comparable firms and control for differences across firms:

 a. Direct comparison: In this approach, analysts try to find one or two companies that look almost exactly like the company they are trying to value and estimate the value based upon how these “similar” companies are priced. The key part in this analysis is identifying these similar companies and getting their market values.

b. Peer Group Average: In the second, analysts compare how their company is priced(using a multiple) with how the peer group is priced (using the average for that multiple). Thus, a stock is considered cheap if it trade at 12 times earnings and the average price earnings ratio for the sector is 15. Implicit in this approach is the assumption that while companies may vary widely across a sector, the average for the sector is representative for a typical company.

c. Peer group average adjusted for differences  Recognizing that there can be wide differences between the company being valued and other companies in the comparable firm group, analysts sometimes try to control for differences between companies. In many cases, the control is subjective: a company with higher expected growth than the industry will trade at a higher multiple of earnings than the industry average but how much higher is left unspecified. In a few cases, analysts explicitly try to control for differences between companies by either adjusting the multiple being used or by using statistical techniques. As an example of the former, consider PEG ratios. These ratios are computed by dividing PE ratios by expected growth rates, thus controlling (at least in theory) for differences in growth and allowing analysts to compare companies with
different growth rates. For statistical controls, we can use a multiple regression where we can regress the multiple that we are using against the fundamentals that we believe cause that multiple to vary across companies. The resulting regression can be used to estimate the value of an individual company. In fact, we will argue later in this book that statistical techniques are powerful enough to allow us to expand the comparable firm sample to include the entire market.