Question for you, do you know what the most common form of valuation of stocks is? Not discounted cash flows, dividend discount models, but relative valuation. Never would have guessed that would you? I know I was shocked when I discovered this fact. Most analysts reports of the sell-side variety use this type of valuation.
Discounted cash flows are difficult, and many different estimates are required to complete those valuations. The fact of the matter is there is no valuation method that is without issues.
However, relative valuation is one method that is easy to use, provided you account for your variable, and understand the metrics that are used, plus the method is great for quick valuations to give a quick and easy way to determine whether the company is worth more analysis.
There is an adage in the investing world that goes something like this; any asset is only worth whatever someone else is willing to pay for the asset.
When valuing a stock, we have to remember that it is a piece of a business, which is easy to forget when using relative valuation as it relates more to the price of a stock and tends to forgo other aspects of the business.
A side benefit of learning how to use relative valuation to find the value of the company is you can use that basis to compare your other forms of valuation, such as a discounted cash flow to see if your story is off compared to the market.
In today’s post, we will learn:
- What is Relative Valuation?
- How to Do You Calculate Relative Valuation
- The Steps in a Relative Valuation
- Examples of Relative Valuation in Action
- Pros and Cons of Relative Valuation
Ok, let’s dive in and discover all there is to learn about relative valuation.
What is Relative Valuation?
Relative valuation is a method of valuation using comparable metrics, referred to also as comparable valuation. Some of the more common metrics used in this type of valuation include:
- Price to Earnings or P/E
- Price to Book or P/B
- Enterprise Value to EBITDA or EV/EBITDA
- Enterprise Value to EBIT or EV/EBIT
And many more, we will discuss this further in a little bit.
Using the relative valuation, we use the value of an asset as compared to the values assessed by the market for comparable or similar assets.
There are many aspects of relative valuation that we need to take into account:
- We need to find comparable assets and assign market values for those assets.
- Next, we need to convert those market values into standardized values since we can’t use the prices as comparables, which leads us to the use of price multiples.
- Finally, we need to compare the value or multiple for the asset we are comparing to the values for comparable assets, all of which allow us to determine whether the asset is under or overvalued.
The value of most assets, from the house or car we buy to the stocks we invest in, is based on how closely they align with similar assets in the marketplace.
How Do You Calculate Relative Valuation?
Using relative valuation, we find the value of an asset is derived from the price of comparable assets, which we standardize using a common variable such as revenues, earnings, cash flows, or book value.
An example of this is the use of an average industry price to earnings ratio to value firms. The assumption being that the other companies in the industry are comparable to the firm we are analyzing. All of that is based on the belief that the market is correctly pricing those other companies, thus making the comparison correct.
Another example is the use of price to book, with companies selling at a discount to book value compared to other companies being considered undervalued.
There are many different examples of these examples, and the list of metrics or multiples used in relative valuation too great to list them all.
Unlike using a discounted cash flow, relative valuation requires our faith in the market is right much more than searching for intrinsic value.
The allure of using multiples is that they are simple and easy for all investors to relate to them. Multiples are useful with a large number of comparable companies, but they tend to be more difficult with unique firms that don’t have a lot of comparables in their industry, or businesses that have little or no revenue, or negative earnings.
Before we dive in and discuss how to use relative valuation to value a company, let’s explore the standardization of value and multiples for a moment.
Standardizing Value and Multiples
Let’s think about the price of a stock for a moment; that price is a function of the value of the equity and the number of shares outstanding in a firm. Because the prices of Mastercard and Visa aren’t comparable, we need to use standardized multiples to compare the companies.
There are four basic multiples that we can use when using relative valuation, and there are many different variations on those themes. The four main multiples are:
- Earnings multiples
- Book value
- Revenue multiples
- Sector-specific multiples
The most important aspect of using any of these multiples or metrics that we choose to use is consistency.
Every multiple we use has a numerator and a denominator. The numerator is either an equity value (such as a price or equity value), or a firm value (enterprise value, which is the sum of the values of debt, equity, and less the cash).
The denominator can utilize equity measures such as earnings per share, net income, or book value. Or we can use firm measures such as operating income, EBITDA, or book value of capital.
One of the key tests to run on multiples is to identify whether both sides of the equation are defined consistently. What do I mean by this?
From Damodaran on Valuation by professor Aswath Damodaran:
“If the numerator for a multiple is an equity value, then the denominator should be an equity value as well. If the numerator is a firm value, then the denominator should be a firm value as well.”
A perfect example of the consistently defined multiple is the price to earnings multiple. The price per share of the numerator is an equity value, and the earnings per share of the denominator is an equity value.
Likewise is the enterprise value to EBITDA multiple, as both numerator and denominator comprise both firm values.
An example of a multiple that is not consistent in terms of mixing equity and firm value is Price to EBITDA, which contains equity in the numerator and firm value in the denominator.
Another aspect of consistency to define how a multiple is defined. For example, using the P/E ratio. There are three forms of the P/E ratio:
- Current PE
- Trailing PE
- Forward PE
So, when using the PE ratio for any company make sure the one you are comparing it is using the same basis of PE ratio, for example, if you are valuing a company using the trailing PE for your company make sure you are using the trailing PEs for all the company’s you are comparing. Otherwise, you risk mixing and matching different definitions, which could lead to errors in valuing companies.
The above example is especially glaring in high-growth sectors where the values can make quantum leaps over the previous quarters, where the effects in a more mature industry like banking are far more minimal.
The other mistake to avoid when using multiples is to avoid negative numbers or selection bias. The use of outliers in averages, for example, can lead to large leaps in averages; huge PE ratios can lead to extremely inflated PE ratios for an industry; likewise, a ton of companies with negative earnings can lead to extremely low multiples.
You have three choices to solve this problem. The first choice is to understand that this bias is there and adjust your multiple to account for this. The other choice is to take all the market value of equity and income, including losses for all the companies in the group and compute the price to earnings ratio for the group. The third choice is to use the median value of the PE ratio, for example, of the group.
Again, there is no best choice, but rather however you decide, it is best to be consistent; for my choice, I am going with the median at this point. But I reserve the right to change my mind at any time and go with the entire sector as a second option.
To be honest, these are the consistency options I picked out that I feel the most relevant to our discussion today, however, if you want to dig deep into the weeds on the subject of multiple definitions, then I highly encourage you to explore any of the relative valuations works that Professor Damodaran has put out there, including his books.
The Steps to Relative Valuation
There are several ways to go about valuing a company using the relative valuation method.
One is to find a company you would like to value, and then find a median for that multiple you would like use to compare and then multiply that by its earnings, for example.
Let’s use a simple example to illustrate.
We want to use a PE ratio to identify the value of a company.
- In an industry, identify five stocks that are similar to the stock we want to value.
- Assume the median PE of those five stocks is 11.4
- The stock we want to value has an EPS of 2.5
- The intrinsic value of the said company would be:
- P = PE x EPS
- P = 11.4 x 2.5
- P = $28.5
- The next step would be to compare it to the median price of those companies and see how it stacks up price-wise compared to those five companies.
That is pretty simple, huh? You can use the same example to value companies using any multiple you wise across any industry, for example, software, banks, retail, real estate, and so on.
The above example illustrates how to value the entire company encompassing all the elements that drive the earnings or revenue of the company.
Another option is to use the relative value of each component of the business to derive the value of the company. That method is the sum of the parts valuation, which is extremely common in analyst’s reports, particularly sell-side analysts. I like this type of valuation in that it helps determine where the value is derived from any given company.
Ok, let’s take a look at some real companies and relative valuations.
Examples of Relative Valuation
For our first example, I would like to look at the big three of the wireless telecom world, Verizon (VZ), AT&T (T), and T-Mobile (TMUS), and we will use the current EV/EBITDA ratio as a comparison for all three companies.
Before I dive into the relative valuations of these companies, I want to share the data set that I use to find both the multiples and the sectors each company is located in:
All the sector data that I will reference will come from the data provided above; I highly recommend you check it out.
Getting back to our example.
The current EV/EBITDA for the sector of telecom services in which all three companies reside is 7.93. To find the relative value for all three companies is to multiply that number by the current EBITDA per share which I will list below:
- Verizon – 10.33 TTM
- AT&T – 7.64 TTM
- TMUS – 14.50 TTM
Now, let’s multiply each of these by the sector multiple and compare them to the current market price.
- Verizon – 10.33 x 7.93 = $81.92
- Current market price – $54.52
- AT&T – 7.64 x 7.93 = $60.59
- Current market price – $29.90
- TMUS – 14.50 x 7.93 = $114.99
- Current market price – $106.33
So, interesting results, according to the relative valuation of all three companies that are currently undervalued by the market, and in the case of Verizon and AT&T quite a bit undervalued.
The next question is, are those values correct? The better question is to evaluate all aspects of the business and determine that value; the other option is to run both companies through a discounted cash flow valuation and check your value using that method. And finally, run all three companies through a reverse DCF to determine what growth rates the market is using to arrive at the price.
As with any valuation method, we have to determine how legitimate do we find these values and to decipher the factors that guide these values.
Let’s try the same process using the book values for a bank. Let’s look at the value of some of the big money center banks.
- Wells Fargo (WFC)
- JP Morgan (JPM)
- US Bank (USB)
- Bank of America (BAC)
- Citibank (C)
- PNC Financial Services (PNC)
- Bank of New York Mellon (BK)
Using my chart to find the current value of price to book value, I find the value of 1.27. Now I will find the current price to book value for each bank, and then we will multiply it by our book value per share to find the relative value.
- Wells Fargo – 1.27 x 39.39 = $50.03
- Current market price – $25.70
- JP Morgan – 1.27 x $75.88 = $96.37
- Current market price = $98.50
- US Bank – 1.27 x $22.39 = $28.44
- Current market price = $37.05
- Citibank – 1.27 x $71.66 = $91.01
- Current market price = $52.70
- PNC – 1.27 x $116.19 = $147.56
- Current market price = $104.02
- Bank of New York Mellon – 1.27 x $42.47 = $53.94
- Current market price = $39.25
Again, an interesting mix of results, at first blush it appears that most of the sector is undervalued and in a few cases quite wildly. All of this makes sense because, as a whole, the banking sector was hit hard during the market crash in March and has not recovered at this point, unlike the Nasdaq.
Ok, let’s try one more example using segments of the business to determine the value of a company. For our example, I would like to stick with banks and analyze JP Morgan, who breaks out the revenues and net income by each segment of the bank. Unfortunately, not every company does this, so it is not possible to analyze them, but JP Morgan does.
All of the numbers for the net income I am pulling from the latest 10-k from 2020. And then, I will multiply it by a comparable PE ratio to arrive at the equity for the bank.
- Consumer & Community Banking
- $16,641 net income x 9.56 PE = 159,087
- Corporate & Investment Bank
- $11,922 net income x 11.98 PE = 142,825
- Commercial Banking
- $3,924 net income x 9.56 PE = 37,513
- Asset & Wealth Management
- $2,833 net income x 11.98 PE = 33,939
- $1,111 net income x 9.56 PE = 10,621
Now we add up all the numbers, and we arrive at an equity value of $383,985 billion in market cap, which compared to the market cap at the end of 2019 that was worth $450,317 billion.
That is an interesting exercise as it illustrates where the value of the company resides and how much of an impact any changes such as interest rates might make to JP Morgan. I love doing that type of breakdown to determine what drives the value of each segment.
Ok, we have illustrated many of the different methods to find value using relative valuation.
Let’s look at some of the pluses and minuses of using relative valuation.
What Are The Advantages and Disadvantages of Relative Valuation
The allure of using multiples is the ease of use, and it is a much quicker way to value a company. In fact, as I mentioned before, almost 85% of all analysts use relative valuation when pricing firms.
Using the relative valuation to value a company is, in fact, pricing because we are using variables that are based on the price of the company, and we are comparing it to the price that the market assigns to a company.
Using comparables is easy, but it can lead to misuse and manipulation. Especially when we are comparing one company to another or a group of others. The bias we have towards different companies or sectors can lead to subjective choices, and what you consider comparable to others might not, which leads to comparison errors as these assumptions about what you consider comparable are often unsaid.
Another issue with using multiples for valuation is it builds in errors that the market might be making in valuing any of the comparable companies.
For example, if the market has overvalued all computer software companies, then using the average or median PE ratio of these companies will lead to us overvaluing the company.
The pros of using relative valuation are that it is quick, easy to use, and gives you a great starting point to determine if you want to continue by digging in finding an intrinsic value of the company.
As with any valuation technique, there are benefits and issues, but our job is to understand those issues and consistently deal with them.
Valuation is as much art as it is science, and the use of relative valuation is part of that combination.
There is plenty of assumptions that are built into using multiples to value a company. The biggest issue to remember is the idea that the market is always right and that every company that you use as a comparison is correctly priced. We all know that is just not true; there are errors in pricing on Wall Street.
My suggestion is to use relative valuation as a guide to help you find companies that are undervalued and then use that information as a starting point for your further analysis.
The hardest part of calculating relative valuation is determining the consistency of your multiples or ratios, and then determining the comparable multiples you are going to employ. Once you have those figured out, it is a breeze.
I encourage you to practice these methods with companies you understand and then branch out from there; you will find it gets easier with practice.
That is going to wrap up our discussion for today.
As always, thank you for taking the time to read this post. I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,