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.