Relative Valuation

The objective of discounted cash flow valuation is to determine the value of an asset based on its cash flow, growth, and risk. Relative valuation seeks to determine an asset's value by examining current market prices for comparable assets. Although multiples are simple to use and make sense, it is equally simple to use them incorrectly. In order to ensure that multiples are utilized properly, a series of tests has been created.

Two components make up relative valuation.

1. First, prices must be standardized in order for assets to be evaluated in respect to one another. Typically, this is accomplished by multiplying prices by revenues, book values, or sales.
2. Locating businesses that are similar to one another is the next stage. This is challenging since no two businesses are alike, and even those in the same industry can differ in terms of risk, potential for growth, and cash flows. It is crucial to understand how to take these variations into account when comparing a multiple across different organizations.

Utilizing Relative Value

Many people make use of relative appraisal. A multiple, such as a price to sales ratio or the value to EBITDA multiple, and a group of comparable firms form the foundation of the majority of stock research reports and many acquisition values. As you can see, this isn't always the case. In fact, comparable firms are those that are in the same industry as the company being valued. In this post, we'll first examine the popularity of relative value and then discuss some potential pitfalls.

What makes relative valuation so common?

This is due to a few factors.

1. Compared to a discounted cash flow valuation, a multiple-based valuation can be completed significantly more quickly and with fewer assumptions.
2. A relative valuation is simpler to comprehend for yourself and to explain to clients and consumers than a discounted cash flow assessment.
3. Finally, as a relative valuation seeks to gauge relative worth rather than intrinsic value, it is much more likely to reflect how the market is currently performing.

Therefore, relative valuation is more likely to produce higher values than discounted cash flow valuations for these stocks in a market where the prices of all internet stocks increase.

Indeed, compared to discounted cash flow appraisals, relative valuations frequently produce values that are closer to the market price. This is crucial for those whose job it is to assess relative worth and who are also subject to comparison-based evaluation.

As an illustration, consider managers of technology mutual funds. The performance of the funds managed by these individuals will be contrasted with that of other technology funds. They will therefore profit if they select technology stocks that are inexpensive in comparison to other technology equities, even if the entire sector is overvalued.

Potential Errors

Relative valuation is both positive and negative in the same sense.

1. Putting together a multiple and a set of companies that are similar makes it simple to create a relative valuation. However, if crucial elements like risk, growth, or cash flow potential aren't taken into account, this can result in divergent evaluations of value.
2. Because multiples reflect market sentiment, employing relative valuation to determine an asset's value may result in values that are either excessively high or excessively low depending on how the market perceives comparable enterprises.
3. All assessments are subject to bias, but relative appraisals are particularly susceptible due to the ambiguity of the underlying assumptions. Practically any price may be justified by a biased analyst who gets to pick the multiple on which the valuation is based and the comparable company.

Values and Multiples with Standardization

The worth of a company's equity and the quantity of outstanding shares in that company are both factors that affect a stock's price. Therefore, a stock split that doubles the number of shares will result in a price reduction of around 50% for each share. Stock prices from different companies cannot be compared since the price of a stock is based on the quantity of equity units in a company.

You must normalize the values in some way if you want to compare the valuations of "similar" businesses on the market. A company's earnings, book value, replacement value, revenue, or position in relation to other businesses in the same industry can all be used to normalize values.

1. Income Multiples
   An effective way to consider an asset's value is as a multiple of the revenue it generates. Most buyers consider the price as a multiple of the company's earnings per share when making a stock purchase. This price/earnings ratio can be calculated using either the trailing PE (current earnings per share) or the forward PE (anticipated earnings per share for the upcoming year). It is customary to consider the worth of the company as a multiple of operational income, or earnings before interest, taxes, depreciation, and amortization, when purchasing a business as opposed to merely the stock in the company. A lower multiple is preferable to a greater one as a buyer of shares or the entire firm. These multiples will be altered, though, by the business being acquired's growth potential and risk.

2. Replacement value or book value Multiples
   Accountants frequently evaluate a company's value quite differently from what the market believes it is worth. The estimated book value is determined by accounting regulations and is mostly based on the original cost of the asset and any subsequent accounting adjustments (such as depreciation). Investors frequently determine whether a stock is overvalued or undervalued by comparing the price they pay for it to its book value of equity (or net worth). Depending on the potential for growth and the caliber of the investments in each, the price/book value ratio might differ significantly from one industry to the next. You calculate this ratio when determining the value of a company using the firm's value and the book value of all assets (not just the stock). You can use the cost to replace the assets as a substitute if you don't think book value is a reliable indicator of the underlying value of the assets. Tobin's Q, or Q Ratio, is the proportion of an organization's value to the expense of replacing its assets.

3. Revenue Multipliers
   Both earnings and book value are accounting metrics that are based on accounting laws and principles. Comparing the value of an asset to the revenue it generates is another approach that is less impacted by accounting decisions.
   For stock investors, this ratio is known as the price/sales ratio (PS). It is determined by dividing the share's market value by its sales value. This ratio can be converted to the value/sales ratio (VS), where the numerator is the overall value of the company. Once more, this ratio varies greatly from industry to industry, largely due to the profit margins in each. However, comparing businesses in various markets and with various accounting systems is much simpler when using revenue multiples as opposed to earnings or book value multiples.

4. Industry or Sector-Specific Multiples
   For businesses in any industry and across the entire market, earnings, book value, and revenue multiples can be calculated. Some multiples, however, are solely employed in a particular industry. For instance, when Internet businesses initially entered the market in the late 1990s, they had essentially no revenues and no book value. Analysts divided each company's market value by the frequency of website visits to determine how much they were each worth. Firms having a low market value per consumer hit were perceived as being undervalued. The market value of equity per customer in the business has recently been used to evaluate online retailers.

Sector-specific multiples can be reasonable at times, but they are risky for two reasons.

1. First, sector-specific multiples can lead to sectors being continuously overvalued or undervalued in comparison to the rest of the market because they cannot be estimated for other sectors or the entire market.Investors could not mind shelling out $2,000 for each time a website page is accessed even though they would never pay 80 times a company's revenue for it. This is due to their ignorance of the high, low, and average values for this metric.
2. Second, a crucial component of effectively using multiples is making the connection between sector-specific multiples and fundamentals. Does a person browsing a company's website, for instance, result in increased sales and money in the bank? Future guesses will be challenging because the solution will vary depending on the company.

The Four Fundamental Steps for Using Multiples

Multiples are simple to misuse and use. You can use multiples wisely and determine whether someone else is abusing them by following four simple steps.

1. The first step is to ensure that each company's definition of the multiple and method of measurement are consistent.
2. Understanding the multiple's distribution over the market as a whole, as well as the businesses in the sector under consideration, is the second step.
3. The multiple must be examined in order to determine not only what fundamental factors influence it but also how modifications to these fundamental factors impact the multiple.
4. Finding the appropriate businesses to compare and take into account any remaining differences between them is the final stage.

References:

1. https://pages.stern.nyu.edu/~adamodar/
2. https://einvestingforbeginners.com/