How to Use Relative Valuation Analysis
Relative valuation methods evaluate an asset’s worth by comparing it to similar assets. This approach helps investors gauge whether an asset is fairly priced by benchmarking it against industry peers or historical averages.
Multiples are one of the most popular relative valuation methods used to assess the value of a stock. They represent the ratio between two financial metrics, such as the price of a stock (P) relative to its earnings per share (EPS). This ratio, known as the Price-to-Earnings (P/E) ratio, falls under the category of price multiples. There are also enterprise value multiples, which consider the overall value of the company.
Price Multiples
Price multiples are among the most used models for relative valuation. Their primary goal is to determine whether a stock is undervalued, fairly valued, or overvalued.
These ratios are often used for comparative purposes. For instance, if we have two identical companies, one with a P/E ratio of 10 and the other with a P/E ratio of 20, we might conclude that the first company’s stock is undervalued, or the second company’s stock is overvalued.
Price-to-Earnings Ratio (P/E)
The P/E ratio is the most popular price multiple because earnings are a critical financial metric. It is logical to compare earnings with the stock price. The numerator, the price, reflects the market value of the stock, while the denominator represents the EPS (total earnings divided by the number of shares).
The P/E ratio can be viewed as the amount of currency units required to purchase one unit of earnings. For example, a P/E ratio of 20 means that $20 is needed to purchase $1 of earnings. The lower the P/E ratio, the cheaper it is to buy a unit of earnings. However, while a low P/E ratio may seem attractive at first glance, the reasons behind it should be investigated.
Variations in P/E Calculation
There are several variations in the calculation of the P/E ratio:
- Trailing P/E: Uses earnings from the last four quarters (or 12 months), divided by the number of shares. This is often preferred by analysts as it uses the most recent data.
- Forward P/E: Divides the current stock price by the projected future earnings per share. Future earnings are based on forecasts.
- Normalized P/E: Takes the average annual earnings of the company over a longer period, such as a business cycle.
When using the P/E ratio for comparative purposes, it is important to maintain a consistent methodology in its calculation. Comparing companies from different industries can lead to incorrect conclusions.
Price/Earnings-to-Growth (PEG) ratio
One of the limitations of the P/E ratio is that it provides a snapshot without considering the company’s growth rate. The PEG ratio offers a solution. The P/E ratio is divided by the projected growth rate for the next year (or three years). For example, with a P/E ratio of 20 and an expected growth rate of 10%, the PEG ratio would be 20/10 = 2. A lower PEG ratio makes the investment more attractive, as the price paid for each unit of growth is lower.
Price to Book Value per Share (P/B)
Like the P/E ratio, the Price-to-Book ratio uses the market price (P) of a stock. The book value per share is calculated from the balance sheet. Essentially, the P/B ratio compares the market price of a share to its book value.
The book value of equity represents the difference between a company’s assets and liabilities as recorded on the balance sheet. This value is then divided by the number of outstanding shares to determine the book value per share. With these data, the P/B ratio can be calculated.
The P/B ratio is particularly useful for companies with highly liquid assets and liabilities, such as banks and insurance companies, because their book value is close to their market value.
A P/B ratio lower than one can be interpreted as a signal that the stock is undervalued. However, additional analysis is necessary to confirm this assertion. Like other price multiples, the P/B ratio is most effective for comparative purposes between different companies.
Price to Sales per Share (P/S)
Another price multiple is the Price-to-Sales ratio, which examines the relationship between the market price of a stock and its sales per share.
Sales for the period (typically a year) are divided by the number of common shares to find the sales per share. This value is the denominator in the P/S ratio. The P/S ratio determines how many units of currency are needed to purchase one unit of revenue.
Many analysts prefer using the P/S ratio over the P/E ratio because sales are less affected by accounting practices and other operational decisions of the company, unlike earnings per share.
One drawback of the P/S ratio is that it does not consider the company’s capital structure. Whether a business generates its revenue through equity or debt can be significant for its competitiveness.
The P/S ratio is particularly effective when analyzing companies in their mature stage, where sales are stable and more predictable.
Enterprise Value Multiples
Enterprise value (EV) multiples are a popular method for assessing a company’s value, often viewed as the estimated price one would pay to acquire the company. EV is calculated as the sum of the market value of common and preferred equity, plus debt, minus the most liquid assets like cash and cash equivalents. These liquid assets are subtracted because, in a potential acquisition, the buyer would also acquire the cash.
EV is preferred by many analysts over market capitalization because it considers the entire capital structure of the company, including debt.
EV/EBITDA
One of the most popular enterprise value multiples is the EV/EBITDA ratio, where EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The EV/EBITDA ratio shows how many times the EBITDA would need to be multiplied to match company’s value. For example, a ratio of 10 means the company is valued at 10 times its EBITDA.
Depreciation and amortization can have a significant impact on companies with substantial fixed and intangible assets, and differing accounting practices can complicate comparisons between companies. Additionally, varying capital structures can further challenge relative analysis. EBITDA is often preferred in these situations because it excludes the effects of interest, depreciation, and amortization, providing a clearer picture of a company’s operating performance.
Comparing EV to EBITDA makes sense because both values disregard the company’s capital structure. Like price multiples, EV/EBITDA is mostly used for comparative analysis—against industry averages, a group of competitors, or another benchmark.
A lower EV/EBITDA ratio can be interpreted as a good investment opportunity, as fewer currency units are needed to buy a unit of earnings (before interest, taxes, depreciation, and amortization).
Other Enterprise Value Multiples
Besides EV/EBITDA, other commonly used ratios include EV/FCFF (EV to Free Cash Flow to the Firm) and EV/EBIT (earnings before interest and taxes). Depending on the specific company’s profile, analysts choose the most appropriate ratios to work with.
For example, if a business has significant depreciation expenses but not amortization, the suitable ratio might be EV/EBITD (excluding amortization from EBITDA).
Another popular ratio is EV/Sales, which is a good alternative to the P/S ratio because it considers the level of debt the company uses to generate its revenue.
Valuation Based on Comparables
After introducing some of the most popular ratios, let’s see how they can be used in practice. For this example, we’ll use the most recognizable ratio, the Price-to-Earnings (P/E) ratio.
Determining Stock Valuation
Whether a company’s stock price is undervalued, fairly valued, or overvalued is determined by comparing its P/E ratio with the industry average, a peer group of similar companies, or another suitable benchmark.
Let’s assume that Company ABC trades at $10 and has a P/E ratio of 15. Meanwhile, the benchmark of similar companies is trading at a P/E ratio of 20. The shares of Company ABC appear undervalued. They would need to rise to $13.33 to match the benchmark’s P/E ratio (20/15).
Comparative Approaches
Analysts can use different comparative approaches, such as comparing the current P/E ratio with the historical average or the average for a specific period. Besides comparing different companies, the P/E ratio is sometimes compared with its own historical values.
Forecasting Future Stock Prices
Based on growth and earnings expectations, the future stock price can be estimated using the P/E ratio. For example, with a current P/E ratio of 10, EPS of $1, and an expected EPS of $1.50 next year, the stock price could be expected to reach $15 next year (if the same P/E ratio is maintained).
Conclusion
In conclusion, multiples provide a practical and widely used approach for valuing companies by comparing key financial metrics with those of similar businesses. By utilizing various multiples such as Price-to-Earnings (P/E), Price-to-Book (P/B), and Enterprise Value-to-EBITDA (EV/EBITDA), investors can gain insights into a company’s relative valuation.
One of the most important decisions is selecting which companies to compare and which multiples are most appropriate for the analysis.
Previous: Discounted Cash Flow Models
