Relative valuation is among the core methods employed by investment experts to arrive at the value of a company relative to its peer companies within the same sector. Relative to intrinsic valuation techniques that entail estimates of cash flows and discount rates, relative valuation involves market-based multiples to help analysts ascertain a company’s position within its peer group.
This guide outlines a systematic approach to conducting relative valuation correctly and efficiently.
Key Principles to Grasp
Relative valuation is based on the same companies being at equivalent multiples. Standard core multiples for valuation are Price-to-Earnings (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), and Price-to-Book (P/B). Based on industry and company-specific circumstances, one can choose multiple. Capital-intensive industry sectors, for example, value EV/EBITDA, whereas financials prefer P/B ratios. Proper use of multiples ensures comparability and relevance by reflecting both the operational and financial similarities between companies.
Step 1: Identify Comparable Companies
The initial responsibility of relative valuation is choosing a peer group. Comparable companies must have similar revenue size, growth opportunities, business models, and geographic exposure. Analysts usually screen companies through databases offering industry classification codes and financial information. The quality of comparables directly impacts valuation. A well-chosen peer group ensures that resulting multiples represent a valid market attitude than random numbers.
Step 2: Gather and Standardize Financial Data
Relative valuation relies on accurate data. Financial reports, market cap, debt, and operating figures are collected by analysts. Data needs to be normalized to compensate for differences in accounting practices, year-ends, and currency denominations. This makes it simple to compare companies in the right way. Strong data integration systems become more important to finance groups with more and more information to process and provide consistency.
Step 3: Compute Valuation Multiples
After standardizing the data, use appropriate multiples for each comparable companies. The most commonly utilized are:
- Price-to-Earnings (P/E): Price per share in the market divided by earnings per share.
- Enterprise Value-to-EBITDA (EV/EBITDA): Enterprise value in total divided by EBITDA.
- Price-to-Book (P/B): Market price per share divided by book value per share.
- Revenue Multiples: Enterprise value divided by revenue in a year, used in most cases for sectors that are high-growth.
Multiples need to be adjusted for exceptional items and unusual gains or losses. This adjustment keeps ratios in line with sustainable operational performance and not just transient aberrations.
Step 4: Benchmark and Analyze
Having calculated the multiples, contrast the target company with the peer group. Calculate mean, median, and interquartile ranges for each multiple to provide reasonable ranges of valuation. Outliers need to be scrutinized to check if differences are due to performance or market aberrations. The outcome must be interpreted in terms of growth opportunities, risks, and profitability by analysts. Successful benchmarking enables investment teams to spot under- or over-valued companies in a systematic manner.
Step 5: Apply Adjustments
Relative valuation involves applying adjustments to capture the target company’s peer differences. Typical adjustments are:
- Size Premium: Smaller companies should be entitled to a discount on account of greater risk.
- Growth Differential: Higher growth assumptions support greater multiples.
- Profitability Differences: Greater or lesser margins than peer medians can support adjustments.
- Geographic Exposure: Emerging market operations may entail some extra risk factors.
Implementing these changes makes it possible for the relative valuation to be consistent with actual market expectations.
Step 6: Synthesize Valuation Range
Once adjustments have been made, calculate a range of valuations for the target firm using adjusted multiples on pertinent financial metrics. The range is an effective investment decision tool. Analysts offer a high, low, and median valuation to represent upside and downside scenarios. The derived range is used as a point of reference for comparison with prevailing market prices and providing buy, hold, or sell recommendations.
Step 7: Merging Data to Provide Current Updates
The key to successful relative valuation is current data. Market conditions and company fundamentals evolve rapidly, and the accuracy of valuations depend on current numbers. Factoring in market prices, earnings releases, and operating statistics help in making real-time updates in valuations. Good data integration systems reduce workflows and errors and allow improved and more credible outputs of valuations.
Step 8: Document and Review Assumptions
Assumptions, data sources, and methodological selections should be completely documented. Transparency of the valuation process facilitates peer review, internal audit, and client reporting. Periodic review of assumptions enables relative valuation to mirror current market conditions and industry drivers. Documentation also aids in compliance and strengthens stakeholders’ credibility.
Conclusion
Relative valuation demands a systematic approach, meticulous data integration, and a conservative comparable study. Proper integration, standardization, and benchmarking of facts are priorities for analysts.
Professional assistance is delivered by InSync Analytics to companies that want to automate their relative valuation process. Their AI solutions, data solutions, and dedicated analysts fuel speed, precision, and efficiency so that investment teams can concentrate on actionable insights and better portfolio performance.
After all, investment professionals can direct their decision-making in any sector by following these steps: peers definition, data gathering, multiples approximation, normalization of differences, and aggregating a panel of valuations. So, always go for trusted companies only who help with this, like InSync. Good luck!
