In relative valuation, the objective is to price the asset based on the market price of the comparable firms, the next questions is then what is the comparable firm, no two firms are identical in terms of risk, growth potential and cash flows. Generally we take firms from the same industry where in the implicit assumption is that firms from the same industry are identical in terms of risk, growth potential and cash flows. It is important to identify the identical firms for applying relative valuation methods. There are basically three steps which need to be followed
Finding comparable assets
Scaling the market prices to a common variable to generate standardized prices that are comparable
Adjusting for differences across assets when comparing their standardized values
Relative valuation technique is more popular than the discounted cash flow technique because
It needs less time and resource
It is easy to explain thus easy to sell
Easy to defend because of lesser number of assumptions compared to DCF
It reflects the current mood of the market
Framework for the Relative Valuation is
Ensure that the multiple is defined consistenty and that it is measured uniformly across the firms being compared
To be aware of the cross-sectional distribution of the multiple, not only across firms in the sector being analyzed but also across the entire market
Understand the relationship of multiple with the fundamentals
Find the right firms to use for comparison and controlling for differences that may persist across these firms
Step 1 – Consistency and Uniformity are key e.g. with Price Earnings ratio (PE ratio) price is current market price of the stock and earnings can be latest fiscal year earnings per share (current PE), it can be earnings per share of last four quarters (trailing PE) or it can be forecasted earnings of the next financial year (Forward PE) so there should be uniformity in the definition of ratio. Similarly there should be consistency in the ratio what this means is that every ratio has numerator and denominator, if numerator is equity value then denominator should also be an equity value e.g. in PE ratio price is market price of the equity and earning is earning per share of the equity so both these are measure of equity same is with EV/EBITDA ratio, in EV, E is enterprise value (value of equity and debt net of cash) and EBITDA is operating profit of the firm before depreciation and amortization both EV and EBITDA are measure of firm.
Step 2 – Distribution of the ratio value across the sector and across the market is equally important. Most of the time the distribution of the ratio value is not symmetrical and are rather positively skewed which result in average value to be higher than the median value and in this type of distribution median is much more representative of the typical firm in the group. It is also important to treat outliers differently, we can remove the outliers when calculating the average and median or we can put an upper and lower cap to the outliers e.g. any value higher than 300 can be taken as 300. The other problem which comes is with every ratio there are some firms for which these ratios can’t be calculated e.g. with PE ratio, firms having negative earnings, PE ratios can’t be computed. In such cases we can take the aggregate price of equity and earnings of all the firms to calculate the average PE ratio of the sector or we can adjust the average PE ratio if the outliers are included in the sample or other solution is to take that multiple which can be computed for all the firms.
Step 3 – Every multiple, whether it is of earnings, revenues, or book value, is a function of the same three variables—risk, growth, and cash-flow-generating potential. Intuitively, then, firms with higher growth rates, less risk, and greater cash-flow-generating potential should trade at higher multiples than firms with lower growth, higher risk, and less cash flow potential. Value of equity in simple terms is Dividend * (1+growth rate)/ (cost of equity – growth rate), if we divide this by earning per share we can get PE ratio so P/E = Dividend * (1+growth rate)/[(cost of equity – growth rate) * Earning per share] = (Dividend/Earning per share) * (1+growth rate)/(cost of equity – growth rate) = Payout ratio *(1+growth rate)/(cost of equity – growth rate). Thus it can be concluded that the key determinants of the P/E ratio are the expected growth rate in earnings per share, the cost of equity, and the payout ratio. Knowing the fundamentals that determine a multiple is a useful first step, but understanding how the multiple changes as the fundamentals change is just as critical to using the multiple. To illustrate, knowing that higher-growth firms have higher P/E ratios is not a sufficient insight if we are called upon to analyze whether a firm with a growth rate that is twice as high as the average growth rate for the sector should have a P/E ratio that is 1.5 times or 1.8 times or 2 times the average price-earnings ratio for the sector. To make this judgment, we need to know how the P/E ratio changes as the growth rate changes.
Step 4 – A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. It would be ideal if we could value a firm by looking at how an exactly identical firm—in terms of risk, growth, and cash flows—is priced. Nowhere in this definition is there a component that relates to the industry or sector to which a firm belongs. Thus, a telecommunications firm can be compared to a software firm, if the two are identical in terms of cash flows, growth, and risk. In most analyses, however, analysts define comparable firms to be other firms in the firm’s business or businesses. If there are enough firms in the industry to allow for it, this list is pruned further using other criteria; for instance, only firms of similar size may be considered. The implicit assumption being made here is that firms in the same sector have similar risk, growth, and cash flow profiles and therefore can be compared with much more legitimacy. There are alternatives to the conventional practice of defining comparable firms. One is to look for firms that are similar in terms of valuation fundamentals. For instance, to estimate the value of equity in a firm with a beta of 1.2, an expected growth rate in earnings per share of 20 percent, and a return on equity of 40 percent, we would find other firms across the entire market with similar characteristics. The other is consider all firms in the market as comparable firms and to control for differences on the fundamentals across these firms using statistical techniques. To control differences we can use subjective adjustments like for a firm with P/E ratio 20 in a sector where the average P/E ratio is 12, if it can be justified that why the P/E ratio of the firm is 20 then we will not recommend that the stock is overvalued otherwise when we compare it with the average P/E of the sector it can easily be concluded that the stock with P/E ratio 20 is overvalued. The higher P/E ratio is may be because of higher growth rate or lower risk or higher cash flow of the firm. The other method to control the difference is to include that variable in the multiple which is driving the firm e.g. in P/E ratio we can include growth number as well then we use P/E/G ratio to compare the firms. We are making two assumptions when we use this method first is that the firms are identical in nature except the growth numbers and other assumption is that the multiple is linearly related with the growth number which may not be the case in real scenario. The third method to control the differences is statistical techniques like regression, in a regression, we attempt to explain a dependent variable by using independent variables that we believe influence the dependent variable. This mirrors what we are attempting to do in relative valuation, where we try to explain differences across firms on a multiple (P/E ratio, EV/EBITDA) using fundamental variables (such as risk, growth, and cash flows). The fundamental variables which determines the equity multiples are given for some of the multiples in the table below
Expected growth, payout, risk
Price-to-book equity ratio
Expected growth, payout, risk, ROE
Expected growth, payout, risk, net margin
In conclusion, when we compare the value obtained from discounted cash flow and relative valuation methods, there may be differences because in discounted cash flow valuation, we assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average.