Relative Valuation Model

What is a 'Relative Valuation Model'

A relative valuation model is a business valuation method that compares a firm's value to that of its competitors to determine the firm's financial worth. Relative valuation models are an alternative to absolute value models, which try to determine a company's intrinsic worth based on its estimated future free cash flows discounted to their present value. Like absolute value models, investors may use relative valuation models when determining whether a company's stock is a good buy.

BREAKING DOWN 'Relative Valuation Model'

Relative valuation uses multiples and benchmarks to determine firm value. A benchmark is selected by finding an average and that average is used to determine relative value.

Relative Valuation Multiples

There are many different types of relative valuation ratios, such as price to free cash flow, enterprise value (EV), operating margin, price to cash flow for real estate and price-to-sales (P/S) for retail.

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is calculated by dividing stock price by earnings per share (EPS). A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued. Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued. This framework can be carried out with any multiple of price to gauge relative market value.

How To Estimate Relative Value of Stock

In addition to providing a gauge for relative value, the P/E ratio allows analysts to back into the price that a stock should be trading at based on its peers. For example, if the average P/E for the specialty retail industry is 20x, it means the average price of stock from a company in the specialty retail industry trades at 20 times its EPS.

Assume company A trades for $50 in the market and has EPS of $2. The P/E ratio is calculated by dividing $50 by $2, which is 25x. This is higher than the industry average of 20x, which means Company A is overvalued. If company A were trading at 20 times its EPS, the industry average, it would be trading at a price of $40, which is the relative value. In other words, based on the industry average company A is trading at a price that is $10 higher than it should be, representing an opportunity to sell.

Due to the importance of developing an accurate benchmark or industry average, it is important to only compare companies in the same industry and market capitalization when calculating relative values.

RELATED TERMS
  1. Absolute Value

    A business valuation method that uses discounted cash flow analysis ...
  2. Comparable Company Analysis - CCA

    A process used to evaluate the value of a company using the metrics ...
  3. P/E 30 Ratio

    The price-to-earnings (P/E) ratio is the valuation ratio of a ...
  4. Valuation

    The process of determining the current worth of an asset or company. ...
  5. Multiple

    A term that measures some aspect of a company's financial well-being, ...
  6. Business Valuation

    The process of determining the economic value of a business or ...
Related Articles
  1. Investing

    How To Choose The Best Stock Valuation Method

    Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one.
  2. Investing

    How To Choose The Best Stock Valuation Method

    There is no single valuation tactic that works in every situation. But a company’s characteristics provide clues to investors about the best method to use.
  3. Investing

    Relative Valuation: Using Stocks To Value Other Stocks

    This effective approach will help you understand which stocks you should be investing in.
  4. Trading

    How to Identify Mispriced Stocks

    Find out how to identify mispriced stocks. Learn about intrinsic and relative valuation methods based on fundamentals, and technical analysis.
  5. Investing

    Relative Valuation Of Stocks Can Be A Trap

    This method of valuing a company can make it look like a bargain when it is not.
  6. Investing

    Value Investing: Why Investors Care About Free Cash Flow Over EBITDA

    Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation.
  7. Investing

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  8. Investing

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  9. Trading

    Peer Comparison Uncovers Undervalued Stocks

    Learn how to put one of the top equity analysis tools to work for you.
  10. Investing

    Equity Valuation: The Comparables Approach

    The main purpose of equity valuation is to estimate a value for a firm or security. There are three primary equity valuation models: the discounted cash flow (DCF), cost and comparable approaches. ...
RELATED FAQS
  1. How do I value the shares that I own in a private company?

  2. Is book value a better metric for company worth than the PE ratio?

    Determine the best situations in which to utilize book value, P/E ratio and other metrics to determine the true worth of ... Read Answer >>
  3. When does a growth stock turn into a value opportunity?

    Learn how fundamental analysts use valuation measures, such as the price-to-earnings ratio, to identify when a growth stock ... Read Answer >>
  4. What is the average price-to-earnings ratio in the banking sector?

    Explore the price/earnings ratio in regard to the banking industry and learn what the average P/E ratio is for most banking ... Read Answer >>
  5. What does the forward p/e indicate about a company?

    Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ... Read Answer >>
  6. How do I calculate the P/E ratio of a company?

    Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance. Read Answer >>
Hot Definitions
  1. Poison Pill

    A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target company attempts to make ...
  2. Glass-Steagall Act

    An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment ...
  3. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  4. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  5. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  6. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
Trading Center