Relative Valuation Definition
Valuing a company can be a challenging task for investment professionals across financial services segments. To that end, relative valuation is one of the most common valuation tools used by investors to determine the value of a company or its individual shares. There are even M&A due diligence software tools that can also help to simplify the process.
Contrary to absolute valuation, which measures a given company’s value based on its internal financial metrics, relative valuation takes a comparative approach to uncovering what a company is truly worth. The basis for most relative valuation methods is assessing the performance of a company in relation to its competitors (or common ratios) in public markets.
A Deeper Look
Industry performance is one of the most important factors applied to relative valuation models, as the company’s worth is determined based on indications from the wider market.
There are various popular relative valuation methods that have been applied across the financial services sector. These ratios form the basis of relative valuations, determining not only how a company might be valued to an investment management firm, but also to the wider stock-purchasing population.
Here we provide a full overview of the key dynamics associated with relative valuation models, including a discussion of the key ratios associated with conducting these analyses.
Types of Relative Valuations
Relative valuations are typically split into two categories: comparable company analysis and precedent transaction analysis.
- A comparable company analysis will value either a private or public company based on its performance in comparison to public companies that operate within a similar market or to wider public indexes. The reason for this is that public companies must publish their financial performance in detail, providing a useful platform for comparing their performance and thus value.
- A precedent transaction analysis looks at previous M&A transactions to determine the value of a company. By analyzing a set of previous transactions within a given industry, investors attempt to come up with an accurate valuation of a comparable company today.
Both of these analyses place a significant level of stress on wider industry performance and apply equity valuation ratios to assist in the process of valuing a company.
Relative Valuation Ratios for Comparable Company Analysis
Valuation ratios allow investors to compare the performance of a specific company to the wider industry and effectively determine whether it is over or undervalued.
The first step in applying a given valuation ratio to a specific company is creating an industry average. Whether you are conducting a comparable company or precedent transaction analysis, each applicable valuation ratio will be compared to the given average.
The distinction between these two types of valuation analyses is that comparable company analyses base the ratio on current public company performance, while precedent transaction analyses look at historical M&A transactions. Let’s take a look at some of the main relative valuation ratios that are widely applied to comparable company analysis.
The P/E ratio is likely the most prominent relative valuation ratio. It is calculated by dividing the stock price of a company by its earnings per share during a given period of time.
- P/E Ratio = Stock Price / Earnings Per Share
Companies that have a lower P/E ratio in relation to their competitors or the wider stock market are perceived to retain more value. This is because the price paid for owning a share in the company is generating a higher level of earnings than other companies.
Many times, companies with lower P/E ratios will see their share prices go up (although that is not always the case). If a given company has a P/E ratio of 15, while most other companies that operate in the same market have a ratio of 20, it would generally be seen as a better investment than other companies operating in the space.
Due to the simplicity of the P/E ratio and its effectiveness at measuring the relative valuation of competitors, it has become one of the most popular methods to measure a company’s comparative value. Typically, a P/E ratio of 15 is seen as standard on the S&P 500.
Other Prominent Valuation Ratios
There are various other prominent relative valuation ratios that are worth noting, as they provide investors with alternative multiples to compare different securities.
- Price to Free Cash Flows – this ratio measures the price of a share in a company to the cash flow generated by each share. Just like P/E ratios, this ratio is compared to other firms operating in an industry, along with the wider stock market.
- Enterprise Value – this ratio attempts to measure the long-term performance and value of a company and is also used comparatively. To calculate Enterprise Value, investors add the company’s total debt to its market capitalization (Stock Price x Outstanding Shares), and then subtract its cash and liquid assets (Market Capitalization + Total Debt – Cash Assets = Enterprise Value).
- Operating Margin – this ratio focuses on the profit a company receives from $1 of sales. Operating margins indicate to investors the level of risk associated with investing in the company.
- Return of Equity (ROE) – this ratio measures the effectiveness of firm’s profit creation efforts (net income / shareholder equity). ROE varies greatly by industry sector, making it a prominent relative valuation ratio.
Investors also look at other valuation ratios such as price/book value per share, price/cash flow, price/sales, among others.
The process of applying these ratios varies when you are comparing public and private companies. Using comparable company analysis to value a private company requires investors to access financial information about the company or make assumptions based on industry trends and past transactions.
Relative Valuation Ratios for Precedent Transaction Analysis
As previously mentioned, precedent transaction analysis looks to previous M&A transactions to measure a company’s value in comparison to similar firm’s that have been sold. During these analyses, investors will look to create ratios based on averages from previous transactions.
Typically, investors look at two main ratios when conducting a precedent transaction analysis:
- Enterprise Value / EBITDA – this ratio is calculated by measuring the Enterprise Value of your range of precedents by their earnings before interest, tax, depreciation, and amortization. The figure is then compared to the company that is being valued to provide an indication of its worth.
- Enterprise Value / Revenues – this ratio is calculated by measuring the Enterprise Value of your range of precedents by their revenues at the time of their sales. It is also then compared to the target company to determine its relative value.
Precedent transaction analyses have the added benefit of applying historical value ratios to help value a company. However, the drawback is that they represent transactions that occurred in the past and may not represent the current market for a given security.
Advantages and Drawbacks to Relative Valuation
Whether conducting a comparable company analysis or precedent transaction analysis, both types of relative valuation approaches present similar benefits to investors that are attempting to value a company. Some of the key advantages include:
- Ability to measure a company’s performance in relation to the wider market and its major competitors
- Capability to apply various valuation ratios that can output a complete picture on the true value of a security within a given industry (transcending stock price in the case of public companies)
- Power to value a company without accessing proprietary data (comparing the value to public companies or previous transactions within private markets)
- Can be conducted through simple observation techniques by the wider public and brokers (when considering the stock market)
Unfortunately, there are also limitations to relative valuation processes with some contending that it is impossible to get a clear picture of a company’s value without analysing its intrinsic financials. Other disadvantages include:
- They are backward looking and historical, which is not always an indication for future performance
- Can be based only on external observations that may be misleading
- Companies can potentially manipulate certain ratios to appear to be performing better than they are
- There is a potential to over-value some industries which could result in a bubble
Despite these drawbacks, relative valuations represent one of the most prominent forces in determining a company’s value and in making investment decisions for both institutional investors and the general public.
Relative Valuations and Investment Professionals
Investment professionals employ relative valuation methods on a day-to-day basis to enhance their investigative and deal sourcing processes.
While many relative valuation ratios are easily accessible publicly, investors that want to value a private company must create their own models to understand whether a potential investment has a competitive advantage in a given sector.
Being able to sufficiently filter through data associated with effectively managing a deal pipeline is a major challenge for any investment professional.
Whether your firm focuses on private or public markets, being able to scrub through the endless amounts of potential leads and access the data you need can be an extremely laborious task.
That’s where SourceScrub comes in.
Access private company data and track your investment banking deal sourcing efforts in an organized, seamless format, so that you can value your targets accurately. Interested in learning more? Request a demo today.
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