Step-by-Step Tutorial: Relative Valuation
Are you interested in investing but find the process of valuing companies intimidating? Don’t worry — one of the most accessible methods is relative valuation. This technique allows investors to compare a company’s value to similar businesses, making it easier to determine if a stock is overvalued or undervalued.
In this step-by-step tutorial, we’ll demystify relative valuation, guiding you through each part of the process. By the end, you’ll have a clear understanding of how to apply this practical approach to your investment decisions.
What Is Relative Valuation?
Relative valuation is a method that assesses a company’s worth based on how similar companies are valued in the market. Instead of calculating a company’s intrinsic value from scratch, you compare it with peer companies using financial ratios. This approach is popular because it’s straightforward and reflects current market sentiments.
Key advantage: It’s quick, easy to understand, and adaptable to different industries.
Step 1: Select Comparable Companies
The first step is choosing your “peer group.” These are companies operating in the same industry, with similar size, growth prospects, and business models.
Tips for selecting comparables:
– Focus on companies with similar revenue, market cap, and geographical presence.
– Use industry classification codes (like SIC or NAICS) to identify relevant peers.
– Check recent financial performance to ensure comparability.
Example: If you’re valuing a small tech startup, look for other small tech firms with similar revenue streams.
Step 2: Choose Relevant Financial Ratios
Next, pick the right ratios to compare. Common ratios include:
- Price-to-Earnings (P/E): Market price per share divided by earnings per share.
- Price-to-Sales (P/S): Market price per share divided by sales per share.
- Enterprise Value-to-EBITDA (EV/EBITDA): Enterprise value divided by earnings before interest, taxes, depreciation, and amortization.
Why these ratios? They provide insight into valuation relative to earnings, sales, or cash flow, depending on the industry.
Step 3: Gather Financial Data
Collect the necessary data for all comparable companies:
- Stock price
- Earnings per share (EPS)
- Sales figures
- EBITDA
- Enterprise value (market capitalization plus debt minus cash)
Reliable sources include financial news sites like Yahoo Finance, Bloomberg, or company filings.
Step 4: Calculate Valuation Ratios
Now, compute the ratios for each comparable:
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P/E = Price / Earnings per Share
P/S = Price / Sales per Share
EV/EBITDA = Enterprise Value / EBITDA
Ensure all data points are for the same period to maintain consistency.
Step 5: Determine the Industry Range
Calculate the average, median, and quartiles of these ratios across your peer group. This helps you understand the typical valuation multiples within the industry.
Example: Suppose the P/E ratios for your comparables range from 15 to 25, with a median of 20. This suggests that similar companies are valued at 20 times their earnings.
Step 6: Apply Ratios to Your Target Company
Finally, estimate your target company’s value:
- Multiply its earnings by the industry P/E average.
- Or, multiply its sales or EBITDA by the corresponding industry ratios.
Example: If your target’s EPS is $2. and the industry median P/E is 20, then:
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Estimated Market Price = EPS x P/E = $2 x 20 = $40 per share
This gives you an approximate market value based on comparable companies.
Additional Tips for Success
- Use multiple ratios to verify your valuation.
- Adjust for company-specific factors like growth prospects or risk.
- Keep updated with industry trends, as ratios fluctuate with market conditions.
- Remember, relative valuation is A Guide, not an absolute measure.
Conclusion
Relative valuation is a powerful, easy-to-learn tool for investors seeking to assess a company’s value swiftly. By selecting similar companies, calculating key financial ratios, and applying industry multiples, you can form an informed estimate of a company’s worth. While it’s not perfect, combining relative valuation with other methods can lead to smarter investment decisions.
Start practicing today, and you’ll develop a sharper eye for undervalued gems in the market! Happy investing!
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