Relative Valuation Models

It is used to compare a firm's value to its competitors to determine its financial worth.

A relative valuation model is a financial valuation method that compares a company to its comparable competitors and uses that information to calculate the company's valuation.

After completing the absolute value model, many people turn to the relative valuation model. The absolute value model looks over a company's intrinsic value, while relative valuation compares the company to its competitors to estimate that value.

The relative value model also utilizes various ratios and benchmarks and compares them to industry averages to determine the value of a company's shares. 

Both of the methods have their unique advantages. For example, the absolute value model allows investors to determine if a company's share price reflects the company's worth.

On the other hand, investors who use the relative value model analyze the financial statements of various companies in one industry and determine whether the company is overvalued or undervalued relative to its competition.

Investors use plenty of ratios within a relative value model to properly analyze a company. These ratios are:

  1. Price to free cash flow

  2. Price to Earnings

  3. Enterprise Value

  4. Operating margin

  5. Price to sales.

These are the main ratios used to analyze a company using a relative value model properly.

A price-to-free cash flow ratio is calculated by:

Market Capitalization

Once you calculate this ratio, you have effectively compared a company's per-share market price to its per-share amount of free cash flow.

This is an important metric to consider because it indicates whether a company can generate additional revenue. Since generating revenue is a significant factor in a company's stock price, keeping track of this ratio is essential.

The price-to-earnings ratio is calculated by:

Price-to-earnings

This ratio helps examine a company's current share price in relation to its earnings per share (EPS). The price-to-earnings ratio is often abbreviated as P/E.

There are three varieties of the price-to-earnings ratio:

  1. Current P/E: valuation based on current earnings

  2. Trailing P/E: valuation based on the last 12 months of earnings

  3. Forward P/E: valuation based on forecasted earnings.

When performing an analysis, it is vital to use the same period P/E ratio throughout all the companies you are analyzing. It would be improper to compare the current P/E of one company to the trailing or forward P/E of another.

This is a crucial ratio to familiarize yourself with because this ratio will help you understand whether a specific stock is overvalued or undervalued compared to stocks of companies in the same industry.

The enterprise value ratio is calculated by

Total Debt

With the help of this calculation, investors can determine what price it would take to take over the company.

The enterprise value is a common alternative to market capitalization. Many investors agree that enterprise value provides a better picture of a company than the market capitalization (MC) calculation. This is because the MC doesn't consider a company's current debt.

This is an important distinction because the debts of a company need to be paid off when purchased. Therefore, the enterprise value calculation is a better estimate of the takeover price of a company.

The operating margin is calculated by

Operating Margin

With this ratio, you can calculate how much money a business makes from its core business in relation to other sources of revenue. It is a good way to see whether a company is being managed properly.

This is an important metric because investors can see whether the general business operations are profitable. In addition, they can ensure the business only survives from profits made through investments. 

A higher ratio indicates a more significant percentage of sales is converted to profit.

The price-to-sales ratio is calculated by

Annual Revenue

With the help of this ratio, investors can determine whether a company's stock is valued correctly. This is because the ratio indicates how the market values a company's sales.

The lower the ratio, the better the investment in the company is. Investors can compare one company's price-to-sales ratio to its companies and determine if the stock is undervalued or overvalued.

Within the relative value model, there are two different types. They are:

Comparable Company Analysis: 

This method examines companies by comparing ratios to similar companies in the public market. Investors can determine whether the company is valued fairly by comparing the ratios.

Precedent Transaction Analysis: 

This analysis method examines historical takeover prices of similar companies when sold. Therefore, investors can approximate the willingness to buy such a company.

Both of these methods have their advantages and disadvantages; let us take a look at these traits:

Advantages and Disadvantages
 Comparable Company AnalysisPrecedent Transaction Analysis
Advantages
  • Easy Calculation
  • Data availability
  • Indicates the market's proposed value
  • Insight into potential trends
  • Based on public information
Disadvantages
  • Can be influenced by non-fundamental factors
  • Can't use for private companies
  • Hard to use for companies with few competitors
  • Limited records on transactions
  • May mislead investors due to variable values
  • Doesn't take market conditions into account

Even with the knowledge of the valuation methods, you need to decide which one to use. These two valuation methods should be utilized depending on the situation you are trying to analyze as an investor.

The precedent transactional analysis is best to use when the company you are analyzing is similar to other companies from a product and financial standpoint. You can determine how much the other companies were acquired for and approximate your company's value.

The comparable company analysis is best for determining whether a company's stock is undervalued or overvalued compared to its competitors.

Implementing Relative Value (Comparing Company Analysis)

There are several other stock models instead of the relative valuation model. Those would be the dividend discount model, absolute value model, and comparables model. Each of them has its unique advantages and disadvantages.

However, what makes a relative value model unique compared to all of them is the ratios that go along with it.

 The relative value model calls for a plethora of ratios and utilizes each one by comparing them to similar companies in the industry.

There are three main steps to be taken to perform a relative valuation model:

  1. Identify assets of the company and figure out the market valuations

  2. Make sure the valuations are standardized to compare to others

    • Part of this is to step is to figure out competitors of said company

  3. Compare the valuations to those of similar companies/competitors.

The previous section identified the different ratios under the relative value model. Let's use those ratios to build a sample model on Mcdonald's based on data collected from May 17, 2022.

Ratios
RatiosMcdonald's (MCD)
Price to Free Cash Flow25.6
Enterprise Value$226.44B
Operating Margin43.7%
Price to Sales7.7
Price to Earnings25.8

This basic example of calculating the required ratios to perform a relative value model. 

Once you, as an investor, have calculated these ratios for your company, the next step is to compare these ratios with those of your competitors.

If you want to find a certain company's competitors, they are listed on each company's 10-K report. The 10-K is a required form for publicly traded companies to fill out. Use this link to learn more about it.

Let's examine one way to use one of the ratios. First, we will focus on the price-to-earnings ratio of McDonald's and compare it to others in the industry. 

The P/E of McDonald's is 25.8. So let's assume the fast food industry has an average P/E value of 20.

This metric implies that McDonald's stock is overvalued. If McDonald's stock had a P/E closer to the industry average, it would be trading at the relative value. Investors would notice this discrepancy and may find the need to sell.

Let's try another example, and this time let's analyze the Alphabet:

The following metrics were calculated using data from May 18, 2022

Ratios
RatiosAlphabet (GOOGL)
Price to Free Cash Flow24.4
Enterprise Value$1.4T
Operating Margin30.5%
Price to Sales6.2
Price to Earnings21.1

As you can see from the numbers, Alphabet has the following ratios describing its financial and operational situation. 

To calculate these numbers, you can use various formulas or online websites that do the calculations.

However, if you would like to calculate the ratios and metrics yourself, the necessary data is provided by the company's financial documents that the public has access to since it is a publicly-traded company.

Now let's assume the industry average for P/E is 24. If you look at the table, the P/E of the Alphabet is 21.1. This would indicate an undervalued stock, and investors may find it reason enough to purchase stock.

An important aspect of all these ratios and models is not making decisions based on only one. It would be ideal for performing an analysis using multiple models and ratios and then deciding if the stock is worth a purchase or sale.

Implementing Relative Valuation Model (Precedent Transaction Analysis)

In the previous section, we primarily focused on examples relating to the comparing company analysis aspect of the relative valuation model. Now let's go over some examples relating to the precedent transactional analysis.

There are a few steps to follow while performing this valuation; they are:

  1. Search for similar acquisitions

  2. Compare valuation metrics

  3. Conclude the value of your company.

Step one is where you, as an investor, search for companies that are similar to your target company and have been acquired. While doing so, take some variables into accounts, such as the company's geography, the type of company, and the type of buyer.

Once that is complete, the second step is to develop the valuation metrics as done in the previous section. 

Once you have these metrics, use them to filter out irrelevant companies and narrow your search to companies in a similar financial situation.

While coming up with the valuation metrics, make sure to include the EBITDA of your company in the analysis.

For the final step, you can use those multiples to determine your company's potential value.

For example, let's say you are analyzing McDonald's and notice the company has an EBITDA of $100 million. Now that you figured out the company's value, you now refer back to your list of similar companies that got acquired.    

You made this list while taking into consideration the geography and the buyer. You verified that your target company had similar business and financial models as the companies on your list.

After verification, you could vet down your list to one company. You figure out that the company was purchased for 5x times its EBITDA. This means that your target company has a valuation of $500 million.

Like that, you have finished the relative valuation model's precedent transactional analysis part.

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Researched & authored by Siddharth Devabhaktuni | LinkedIn

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