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Relative Valuation

Basis and Categorization

Relative valuation is a valuation approach that estimates the value of an asset by comparing it to the values of similar or comparable assets.

1. Basis for Relative Valuation:

  • Market Efficiency (or Inefficiency): Relative valuation relies on the idea that similar assets should trade at similar prices (or multiples of financial metrics). This approach assumes that the market, on average, prices assets reasonably well, even if it is not perfectly efficient. Relative valuation uses the "wisdom of the crowd" or "prevailing market sentiment".
  • Law of One Price: Assets with similar characteristics should have similar prices. Relative valuation seeks to identify assets that are mispriced relative to their peers.
  • Comparable Assets: The key to relative valuation is identifying comparable assets. These can be:
    • Comparable Companies: Publicly traded companies that operate in the same industry, have similar business models, and similar risk profiles.
    • Comparable Transactions: Recent mergers, acquisitions, or divestitures involving similar assets.
  • Standardized Values (Multiples): To compare assets of different sizes, relative valuation uses standardized values, or multiples. A multiple is a ratio of a company's market value (or enterprise value) to a financial metric (e.g., earnings, revenue, book value). Common multiples include:
    • Price-to-Earnings Ratio (P/E): Market capitalization / Net Income.
    • Enterprise Value-to-EBITDA (EV/EBITDA): Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization.
    • Price-to-Book Ratio (P/B): Market Capitalization / Book Value of Equity.
    • Price-to-Sales Ratio (P/S): Market Capitalization / Revenue.
  • Benchmarking: Comparing the multiples of the target asset to the multiples of comparable assets to determine whether it is overvalued, undervalued, or fairly valued.
  • Simplicity and Speed: Relative valuation is often quicker and easier to implement than DCF valuation, as it does not require detailed forecasts of future cash flows.

2. Categorization of Relative Valuation Models:

Relative valuation models can be categorized based on several factors:

  • Type of Multiple:
    • Equity Multiples: Use market capitalization as the numerator (e.g., P/E, P/B, P/S). These are appropriate for valuing the equity portion of a company.
    • Enterprise Value Multiples: Use enterprise value as the numerator (e.g., EV/EBITDA, EV/Revenue, EV/EBIT). These are appropriate for valuing the entire company (enterprise value).
  • Financial Metric Used:
    • Earnings-Based Multiples: Use earnings as the denominator (e.g., P/E, EV/EBITDA, EV/EBIT). These are appropriate for profitable companies with stable earnings.
    • Revenue-Based Multiples: Use revenue as the denominator (e.g., P/S, EV/Revenue). These are useful for valuing companies with negative earnings or volatile earnings.
    • Book Value-Based Multiples: Use book value as the denominator (e.g., P/B). These are appropriate for valuing companies with significant tangible assets.
    • Sector-Specific Multiples: Use financial metrics that are specific to a particular industry (e.g., subscribers for cable companies, barrels of oil equivalent for energy companies).
  • Method of Comparison:
    • Direct Comparison: Simply comparing the multiples of the target asset to the multiples of comparable assets.
    • Regression Analysis: Using statistical techniques to identify the factors that drive multiples and to estimate the fair multiple for the target asset based on its characteristics.
  • Scope of Comparables
    • Narrowly Defined: Only using companies in same industry and similar size.
    • Broadly Defined: Using companies in related industries or with similar financial characteristics, regardless of industry.

The choice of relative valuation model depends on the specific characteristics of the asset being valued and the availability of comparable assets.

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