Relative Valuation

Concept

Relative Valuation, also known as Comparables Analysis or Multiples Valuation, is a valuation method that estimates a company’s worth by comparing it to similar businesses (or transactions) using market-driven metrics. Instead of projecting detailed cash flows, analysts rely on established valuation multiples—such as Price-to-Earnings (P/E) or EV/EBITDA—to gauge how the market is pricing comparable companies.

Key Multiples and Ratios

1. Price-to-Earnings (P/E)

   • Formula: $\text{Share Price} / \text{Earnings per Share (EPS)}$
   • Interpretation: Measures how much investors are willing to pay for each dollar of the company’s earnings. More relevant when net income is a reliable measure, and capital structure differences aren’t too large across peers.

2. Price-to-Book (P/B)

   • Formula: $\text{Share Price} / \text{Book Value per Share}$
   • Interpretation: Often used for financial institutions, where book value (shareholders’ equity) is a key driver. A P/B ratio above 1 suggests the market values the company’s net assets above their balance sheet carrying value.

3. EV/EBITDA

   • Formula: $\text{Enterprise Value} / \text{EBITDA}$
   • Interpretation: Commonly used for capital-intensive companies because EBITDA approximates operating cash flow. EV/EBITDA is considered less sensitive to capital structure and tax differences.

4. EV/Sales

   • Formula: $\text{Enterprise Value} / \text{Revenue}$
   • Interpretation: Useful for early-stage or high-growth companies not yet profitable. It benchmarks the value of each dollar of revenue across companies with similar business models.

5. EV/EBIT

   • Formula: $\text{Enterprise Value} / \text{Earnings Before Interest \& Taxes}$
   • Interpretation: Similar to EV/EBITDA but factors in depreciation and amortization, making it more comparable across companies with similar accounting practices and CapEx profiles.

Steps in Relative Valuation

1. Identify Comparable Companies or Transactions

   • Look for peers in the same industry or those with similar business models, growth rates, and margins.
   • For precedent transactions, focus on deals in the same sector or similar transaction sizes.

2. Select Relevant Multiples

   • Choose metrics (P/E, EV/EBITDA, etc.) based on the company’s financial profile, capital structure, and industry norms.

3. Calculate Multiples for the Comparables

   • Gather each peer’s market data: share prices, outstanding shares, enterprise values, earnings, revenue, etc.

4. Determine a Valuation Range

   • Look at the comparable group’s multiples (e.g., mean, median, high, low).
   • Apply a suitable multiple (or range of multiples) to your target company’s corresponding metric (e.g., your company’s EBITDA).

5. Adjust for Differences

   • Consider outliers or differences in growth prospects, operational scale, capital structure, or profitability margins. You may adjust your target’s valuation up or down accordingly.

Strengths and Weaknesses

Strengths

• Market-Driven: Reflects how the market is currently valuing similar businesses.
• Quick and Intuitive: Less intensive than building a full DCF model.
• Widely Recognized: Investors, bankers, and analysts regularly use these multiples.

Weaknesses

• Assumption of Similarity: Requires genuinely comparable peers; differences in growth, margins, or business models can undermine the analysis.
• Market Fluctuations: Subject to overall market sentiment—multiples can become inflated or depressed based on broader market cycles.
• Limited Forward-Looking Insight: While it can indicate how others are valued, it doesn’t provide intrinsic insight into a firm’s long-term potential as a DCF might.

Simple Example

Assume you want to value a software company, XYZ Corp, and you have three listed comparable software firms:

Company	Market Cap (M)	Net Debt (M)	EBITDA (M)	EV (M)	EV/EBITDA
A	1,000	100	100	1,100	11.0x
B	1,500	300	150	1,800	12.0x
C	800	0	80	800	10.0x
Median	-	-	-	-	11.0x

XYZ Corp has:

• EBITDA: $90M
• Net Debt: $50M

Step 1: Determine a Median Multiple

From the table, the median EV/EBITDA multiple is 11.0x.

Step 2: Apply the Multiple to XYZ Corp

$\text{Implied Enterprise Value (EV)} = \text{EBITDA} \times \text{EV/EBITDA Multiple}$ $= 90M \times 11.0x = 990M$

Step 3: Calculate Equity Value

If XYZ’s net debt is $50M, then:

$\text{Equity Value} = \text{Enterprise Value} - \text{Net Debt} = 990M - 50M = 940M$

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Takeaway

Relative Valuation is an essential tool for quickly comparing companies and assessing how the market values similar businesses. While it doesn’t replace a thorough intrinsic analysis like a DCF, it offers a timely snapshot of market-based expectations, making it a vital part of a well-rounded valuation approach.