What is the Importance Of Relative Valuation

Relative Valuation

Generally speaking, ‘valuation’ can be defined as the process for finding the ‘value’ of anything. In the world of finance, value of anything (tangible or intangible) would be reflected by the price that potential buyers and sellers agree to conduct the transaction for the transfer of ownership, which may obviously change with time. The demand and supply for are the drivers of the process of ‘price discovery’ of any asset in any market.

A transaction for transfer of ownership of any asset is possible only when there is an overlap between the two price ranges as shown below:

Zero to maximum price that any potential buyer is willing to pay (say PB,Max)
Minimum price that any potential seller is ready to sell at to infinity (say PS,Min)

Although there are numerous asset classes such as (equity, fixed income, cash equivalents, alternative investments etc.), their prices are still driven by the fundamental principles of demand and supply. Let’s look at the two possible scenarios:

There is no overlap between the two ranges : No Transaction

This kind of scenario may be observed when everybody is extremely bullish about the future of the asset (when nobody wants to sell and everybody wants to buy) OR when everybody is extremely bearish about the future of the asset (nobody wants to buy and everybody wants to sell).

There is an overlap between the two ranges: Transaction takes place at a price in the overlap of ranges

This is a very common scenario at any market place where any sale-purchase transactions take place. However, the price at which the transaction takes place is governed by the bargaining power of the participants. In case of financial assets, trading exchanges play an extremely important role of providing the platform for potential buyers and sellers to monitor the prices of various assets, and connect with each other to participate in the process of conducting the transactions for transfer of ownership.

Given this context, the definition of valuation would need some modification.

For potential buyers, valuation is the process of finding the threshold PB,Max. On the other hand, for potential sellers (owners of the asset), valuation is the process of finding the threshold PS,Min.

But how would anyone find these thresholds?

One of the key methods is to conduct discounted cash-flow (DCF) analysis, which is based on the principle of time value of money. In this method, future cash-flows which may be potentially earned from the asset are projected and are discounted at a rate corresponding to the perceived risk to find the present value. However, DCF is a reasonably time-taking process and needs special skills (such as financial modeling and in-depth knowledge. In case of equities, projection of future cash-flows is even more challenging given the ever-changing business scenarios, emerging strategies, evolving technologies and un-predictable consumer behavior. This is when Relative Valuation comes to the rescue, to a certain extent. Relative Valuation is the process of comparing certain characteristics and parameters (e.g. financial ratios, growth rates etc.) with those of similar other assets to derive the price of the asset.

A very common and traditional ratio which is used to compare various equity stocks traded at exchanges is ‘P/E’ (Price to Earnings Ratio, calculated as ratio of Price per share and Earnings per share). Similarly, there are various other financial ratios used for relative valuation such as:

P/S (Price to Sales)
EV/ EBITDA (Enterprise Value to Earnings before Interest, Taxes, Depreciation and Amortization)
PEG (Price/ Earnings to Growth)

Relative valuation is a much quicker process and certainly helps when as an investor you want to screen and shortlist the stocks for building the consideration set of potential investments OR for finding if an existing investment of yours is over-valued compared to its peers and should be sold off.

While Relative Valuation is a convenient process, it’s also fraught with certain dangers and deserves a lot of caution to be exercised by the analyst:

As a financial analyst, it is critical to understand the way in which various financial ratios are derived from the financial statements e.g. whether the P/E ratio should be calculated on a trailing basis or on forward basis, how should the earnings be calculated and adjusted to make an apple-to-apple comparison
Suitability of financial ratios to various industries e.g. P/B (Price to Book value) ratio may be relevant for stocks from banking sector but not as much for the stock of a growing bio-tech company
While comparing ratios for companies from the same industry sector, various other aspects such as maturity, size, growth etc. should also be considered
Also, relative valuation should be conducted in the overall context of the business and not in isolation.
The decision should never be taken purely on the basis of a single ratio. Multiple financial ratios should be considered and sound judgment would need to be applied in cases where different ratios are counter-intuitive.

To be able to use Relative Valuation skillfully, one needs to be able to pick the appropriate ratios for comparison, understand financial statements and be able to normalize various ratios through adjustments.

Quick Summary:

Demand, Supply, Bargaining Power and Existence of a marketplace are key requirements for price discovery and for transaction to take place. Valuation is important for potential buyers and sellers to be able to decide the threshold prices respectively for buying and selling. While DCF is a detailed and long drawn process, relative valuation is relatively simpler process useful for stock-picking, making buy/sell decisions but must be used with reasonable understanding of the background and ability of understanding the mathematics and finance behind calculations of the ratios.