Relative Valuation Model - Explained
What is a Relative Valuation Model?
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Table of ContentsWhat is a Relative Valuation Model?How Does a Relative Valuation Model Work?Relative Valuation MultiplesRelative Valuation Model and Absolute Valuation ModelHow to Estimate the Relative Value of Stock
What is a Relative Valuation Model?
A type of business valuation method that analyzes the value of a company to the value of its competitors or industry peers in order to determine the financial worth of such a company is termed the Relative Valuation Model. It makes use of multiples, averages, ratios, and benchmarks to determine a company's worth. It is also used by investors to make informed decisions before buying a company's stock. This model serves as an alternative to the Absolute Value Model, which without taking a company's competitors or industry peers into consideration, tries to analyze a company's real value based on its estimated future cash flows discounted to their present value.
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How Does a Relative Valuation Model Work?
Relative Valuation Multiples
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, amongst others are all different types of relative valuation ratios. The price-to-earnings (P/E) ratio is one of the most popular relative valuation multiples and expressed as a company's share price as a multiple of its earning; is calculated by the division of the stock price by earnings per share (EPS). Any company whose high P/E ratio is trading at a higher price per dollar of earnings that its competitors are said to be overvalued and vice versa.
Relative Valuation Model and Absolute Valuation Model
In a Relative Valuation Model, a company's peers and competitors are taken into consideration before analyzing and determining its value. In an Absolute Valuation Model, on the other hand, no consideration is given to a company's competitors before analyzing and determining its value. While the absolute model which is expressed as a plain dollar amount gives little detail about its relative value, the relative model gives more details by taking a multiple analysis approach which involves; identifying comparable assets, conversion of market values into standardized values relative to a key statistic and applying the valuation multiple to the key statistic of the asset being valued.
How to Estimate the Relative Value of Stock
As the P/E ratio provides a benchmark for the relative value, it also helps analysts arrive at the price a stock should be trading at in relation to its peers. Looking at Company A having an EPS of $2 and trading in the market for $60, its P/E ratio is derived by the division of $60 by $20 which equals 30x. This value is way higher than the industry average of 20x and depicts Company A as overvalued. When calculating relative values, it is very important for analysts to only compare firms operating in the same industry and market capitalization in order to develop an accurate gauge or industry average to be used for firms being analyzed.