5 Benefits of Relative Valuation with Formula and Example
Updated: Oct 14, 2022
This method was developed by Robert Warren Miller in his book "Valuing Companies: A Guide to Valuation Tools and Techniques".
The Relative Valuation Method is a valuation method that compares the company to other similar companies. The idea is that if you can find other companies that have similar characteristics, then you can use the value of those companies to determine the value of your company.
It compares your company's financial data with other similar businesses and uses ratios such as EBITDA, sales, net income, or gross margin to determine its value. It considers industry trends and other external factors such as competitive forces and regulatory changes that may impact your business's profitability.
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Types of Relative Valuation
There are two main types of relative valuation methods:
Peer-to-Peer Valuation —
This is when you use other startups in your industry as the basis for comparison. The more successful and established your competitors are, the higher their prices will be and the more likely it is that investors will consider paying similar amounts for your business.
Benchmarking Method —
This is when you use publicly traded companies as a benchmark for pricing your business. It's easier than peer-to-peer valuations because there's no guesswork involved about how much other investors may be willing to pay for your startup; instead, you can look at the public price history of similar companies and project how much yours might be worth based on that data.
Why Understanding Relative Valuation is so Important?
A relative valuation is an approach to stock analysis where a company's value is determined by comparing its financial performance with that of its peers. Relative valuation is considered more useful because it helps investors determine whether a stock is undervalued or overvalued compared to other stocks in the same sector.
This method of evaluation has been used for centuries, but it became popular as an investment tool during the late 20th century. It can be applied to individual companies or entire industries and provides investors with a broad range of information that can help them make better-informed decisions about their portfolios.
Relative valuation involves comparing two companies' current financial performance and future growth potential using ratios such as price-to-earnings (P/E), the price-to-book value (P/BV), and price-to-sales (P/S). Investors also use this method to compare two industries by looking at how much money each sector makes or spends on research and development (R&D). This approach helps them determine which sectors offer the best opportunities for growth over time.
Basic Formula or How to Calculate the Relative Valuation?
The relative valuation method is a technique to determine the value of a company by comparing it to other publicly traded companies. It is based on the premise that companies in the same industry or similar market conditions should trade at about the same price.
Price-to-Earnings Ratio (P/E Ratio)
Compares a company's current share price with its earnings per share (EPS). The P/E ratio measures how much investors are willing to pay for each dollar.
PEG stands for price/earnings-to-growth Ratio. It’s a valuation metric that takes the PE ratio, which measures the price of a stock relative to its earnings and divides it by the expected growth rate in earnings over the next few years.
It gives you an apples-to-apples comparison between two stocks with different PE ratios, so you can see which one is cheaper on a price/earnings basis.
For example, if you have two stocks with similar PE ratios and one is expected to grow at 10% while the other is expected to grow at 15%, you can use the PEG ratio to determine which one is more reasonably priced given the expected growth rate.
It gives you an idea of how expensive or cheap a stock might be relative to its growth prospects. A company with a high PEG ratio may not necessarily be overvalued if it has lots of room for growth — but it does indicate that investors are expecting greater returns from this company than from other companies in its industry with similar PE ratios.
Book Value
Defined as the value of all assets less all liabilities.
A common definition for book value is shareholders' equity divided by the number of shares outstanding.
Price to Book Value Ratio (P/B)
The ratio of a company's share price to its book value.
Price to book value can vary significantly from industry to industry depending on how profitable companies are and how much cash they have on hand relative to their liabilities.
For example, a high price to book value stock in an industry with low profitability may indicate that the market expects more growth in the future than a low price relative to book value stock in an industry with high profitability.
Price to Sales Ratio
The price to sales ratio is calculated by dividing the market capitalization by the total sales of 12 months or annual revenue. The higher the number, the more expensive the stock is relative to its peers. The lower the number, the cheaper it is relative to its peers.
The price to sales ratio is a great way to compare companies that operate in different industries or sectors. It allows investors to compare companies based on their performance rather than on their growth rates alone.
Price to Cash Flow Ratio
The price-to-cash-flow ratio measures the valuation of a firm using its cash flows. The price paid for a share is divided by the amount of cash generated by the business per share.
Earnings Per Share
The relative valuation method compares a company's stock price to earnings per share (EPS). It is calculated by dividing Net income less preferred dividends by the total number of shares. If a company’s EPS is greater than its peers’, then its stock price should be higher than theirs. This can be done by calculating an average EPS for all companies in an industry or sector, for example, then comparing each company's EPS with that average.
For example, if Company A has consistently outperformed Company B over five years, then Company A may be worth more than Company B even if they have identical fundamentals today.
Example With Calculation
1. If you have a SaaS product with $5 million in annual revenue and are seeking $10 million in outside investment, you can use this method to determine whether your target valuation is reasonable. First, find a company that has similar revenue but has not yet raised capital or been acquired. Next, see what their valuation is based on the information available online (post-money). In this case, $10 million divided by $5 million would be 2x revenue multiple (2x). This means that if I were to sell my company for $20 million a year from now, I would be valued at 2x revenue ($20m / $10m = 2x). If my target value was 2x revenue, then I would be looking for investors willing to pay $12 million for my company (2x x $10m = $20m).
2. Let’s say you have an early-stage company that has raised $40 million in two rounds, with a valuation of $100 million in each round. And let’s say 20 other companies like you have also raised $40 million in two rounds with a valuation of $100 million each time. Then your relative price would be 4x (4 times) because 4x is the average multiple across all 20 companies. This means that if you want to sell your company for $100 million, it might make sense for investors to pay somewhere between $400 million and $500 million for it!
Advantages of Relative Valuation
1. It's easy to understand and apply.
2. It's flexible and can be used with any type of business or industry.
3. It doesn't require a lot of information about the company or its industry.
4. It doesn't require much time from management and analysts.
5. There is no need for an analyst's opinion on projected growth rates, earnings, or cash flow.
Disadvantages of Relative Valuation
1. It doesn’t account for growth potential or profitability—only dilution from previous rounds.
2. It assumes that all companies are equal in terms of quality and growth potential (which isn’t true).
3. The challenge with this method is that it requires market research and analysis to determine which companies are truly comparable to yours.
4. The relative valuation method is only as good as the comparable you use. If you use a bad comparable, your valuation will be inaccurate.
5. Startups that have yet to prove themselves may be overvalued than they should be by this approach. It's easy for companies to manipulate their numbers to make them look better than they are.
Conclusion
The main benefit of this method is that it is easy to understand and apply, making it ideal for people who are new to investing or any type of financial analysis. The relative valuation method can also be used to compare companies' dividend yields — which are essentially their payouts as percentages of share prices — to one another. And it works not only for stocks but also for bonds and mutual funds.
Key Takeaways
The relative valuation method only looks at stocks that have similar business metrics.
Don't fall for accounting tricks and manipulation. Learn to value growth companies correctly.
Understanding the relative valuation method gives you an advantage when trading.
To do relative valuation, you need to use ratios like price/earnings, price/sales, and cash flow.
You can read our other blogs here:
Discounted Cash Flow Valuation: What, How, and Methodology in 4 Easy Steps