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# Basics of Relative Valuation

The basic methods of valuing an asset are two:

1. Absolute or intrinsic valuation

2. Relative Valuation

Absolute or intrinsic valuation is used by investors and analysts to assess the present value of an asset by discounting future net cash flows (inflow – outflow for the period) which are then summed up to arrive at the asset’s NPV (Net Present Value). This article tries to expand on how and when to use relative valuation techniques.

Relative Valuation:

Relative Valuation is based on how similar assets are currently priced in the market.

So, to begin with, relative valuation method requires finding comparable assets that are priced in a similar fashion. To achieve this, analysts or investors typically compare the stock prices of other companies operating in the same sector.

For instance, for Exxon Mobil Corporation (XOM), the single largest publicly-traded energy company in the world, the closest competitors include: Chevron Corporation (CVX), BP plc (ADR) (BP), and Royal Dutch Shell (ADR) (RDS.A). Therefore, an analyst looking at Exxon will also look at how the stocks of these other companies have been valued to get an idea of a fair valuation for Exxon stock.

The second step would be to scale the market prices of assets to a common variable so that a comparable number can be arrived at. This is essential when assets of different sizes and metrics are being used for comparision. For instance, at the end of fiscal year 2013, Exxon recorded revenues of \$390.3 billion. Chevron, on the other hand, recorded revenues of \$211.7 billion in the same time frame. Both these companies also reported different earnings per share (EPS), gross margins and so on and so forth. In the context of stocks, equalizing these two companies will usually involve converting the market value of their equity or firm into multiples of earnings, book value or revenues.

The final step in the relative valuation process involves adjusting for differences across assets while comparing their standardized values. In the case of stocks, differences in pricing can arise from differences in the fundamentals of companies. For instance, high-growth companies (like certain tech companies) trade at higher multiples than lower-growth companies in the same sector. For example, Tesla Motors Inc ( TSLA) is currently trading at a forward price-to-earnings (P/E) multiple of 97.15x as analysts expect its earnings to grow at a compounded annual rate (CAGR) of 92.2% in the next three years. On the other hand, Ford Motor Company ( F) is currently trading at a forward P/E multiple of only 10.47x since its earnings are expected to grow at a CAGR of only 7.6% in the same period as its growth is approaching maturity. Both companies belong to the automobile manufacturing industry.

Analysts adjust for these differences based on their own assumptions and predictions about a certain sector or industry, which means a relative valuation of stocks also involves a lot of qualitative analysis. Analysts with better and more believable assumptions and predictions are given credit for better valuations, and are regarded and respected more highly in the industry.

Here are four types of multiples that investors can refer to while performing basic level relative valuations on their own.

1. Earnings Multiples

One way to value any asset is to look at its price as a multiple of the earnings it generates. When buying stocks, it is common to look at the per share price of the stock as a multiple of what the company earns per share.

There are different variations of the price-to-earnings (P/E) ratio. It can be calculated by using current earnings per share (earnings over the past four quarters), which gives the ‘trailing twelve month’ (ttm) P/E. Expected EPS for the next 12 months divided by the current stock price gives a ‘forward’ P/E.

The S&P 500 Index is currently trading at a one-year forward P/E multiple of 15.32x – at a premium of 16.4% to its three-year average forward P/E multiple of 13.15x. Any stock trading above the S&P 500’s forward P/E multiple will be ‘trading at a premium’ to the S&P 500 index; on the other hand, any stock trading below the S&P 500’s P/E will be ‘trading at a discount’.

2. Book Value or Replacement Value Multiples

Investors often look at the price they are paying for a particular stock as a multiple of the book value of an equity to gauge how much over- or undervalued a stock is. The price/book value ratio that emerges can vary widely across industries. It is also known as the “price-equity ratio.”

The price-to-book (P/B) value ratio is suitable when you are comparing companies whose future earnings growth can be determined mostly through growth in their assets. It is calculated by dividing the price of a stock by the company’s book value per share in the latest quarter.

Berkshire Hathaway Inc. (BRK.A) reported in its financial results for the first quarter of fiscal 2014 (1QFY14; ended March 31, 2014) that the book value of its Class A shares went up 2.6% year-over-year (YoY) to \$138,246 during the quarter. This means that Warren Buffett’s company has a P/B ratio of 1.37x at its current stock price.

Investors can also use the Price-to-Tangible Book Value (PTBV) ratio, which is calculated by dividing the price of a stock with the per share total tangible assets of a company. The tangible book value represents the amount of money an investor would receive if a company ceases operations and liquidates all its assets at the value recorded on the company’s accounts.

3. Revenue Multiples

An alternative to using earnings and book value multiples is looking at a stock’s price and the revenues a company generates. The price-to-sales (P/S) ratio is calculated by dividing the market price of a stock by the revenues generated per share by the company. This ratio can also be modified as the enterprise value-to-sales (EV/Sales) ratio, in which the numerator becomes the theoretical takeover price of the company.

Revenue multiples are used for companies with negligible or no earnings, but high growth potential. Examples include social media companies in the technology sector. These include LinkedIn Corp (LNKD) and Twitter Inc ( TWTR), which are expected to convert their sales into earnings in the future. LinkedIn is currently trading at a P/S ratio of 10.51x, whereas Twitter is trading at a P/S ratio of 23.15x.

4. Sector-Specific Multiples

While earnings, book value, and revenue multiples can generally be used across various sectors, there are some multiples that are specific to certain sectors. For instance, in the energy sector, the Enterprise Value divided by Proven and Probable Reserves (EV/2P) is used to value upstream companies. It gives an indication of how much a field is worth on a per barrel basis. However, this ratio should not be used in isolation, since not all reserves are the same for every company.

Currently, Exxon Mobil Corporation (XOM) is trading at an EV/2P ratio of 18.63x, while Chevron Corporation (CVX) is trading at an EV/2P multiple of 22.05x.

Conclusion

Although all these valuation techniques will help an investor carry out a decent analysis of a particular stock, there will still remain certain factors that impact valuations but cannot be accounted for in these multiples.

For instance, if a biotech company receives a drug approval from the US Food and Drug Administration (USFDA), its valuation will change drastically as analysts’ revenue and earnings expectations will change significantly. On the other hand, if a biotech company does not receive a drug approval, its valuation will be pressured as its revenues and earnings will be expected to grow at a slower rate in the future.