Relative valuation is a method used to determine a stock's value by examining how the market prices similar companies. To understand this, think of buying a house: you'd typically look at what similar homes in the neighborhood have sold for, rather than determining the value of the house based on its individual components. Likewise, in stock investing, people often gauge whether a stock is cheap or expensive by comparing its price to that of similar stocks.
Valuation Using Multiples
The term "multiples" refers to various indicators that can be used to value a stock. A multiple is a ratio, calculated by dividing the market value of an asset by a specific financial metric. These standardized financial metrics allow for value comparisons among companies of different sizes. For example, if we want to compare the prices of two differently sized buildings in the same location, we'd look at the price per square foot to make a fair comparison.
Standard Multiples
Prices can be standardized using variables like earnings, cash flows, book value, or revenues. We provide information on several ratios:
- P/S. The Price to Sales ratio is a valuation multiple that compares a company’s market capitalization to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales.
- P/E. The Price to Earnings ratio is a valuation multiple that compares a company’s market capitalization to its net income. It indicates the dollar amount an investor can expect to invest in a company in order to receive $1 of that company’s earnings.
- P/OCF. The Price to Operating Cash Flow ratio is a valuation multiple that measures the value of a company’s market capitalization relative to the operating cash flow it generates. Some analysts prefer P/OCF over P/E since earnings can be more easily manipulated than cash flows.
- P/FCFE. The Price to Free Cash Flow to Equity ratio is a valuation multiple that compares a company’s market capitalization to the amount of free cash flow available for equity shareholders. This metric is very similar to the P/OCF but is considered a more exact measure, owing to the fact that it uses free cash flow, which subtracts capital expenditures (CapEx) from a company’s operating cash flow.
- P/B. The Price to Book Value ratio is a valuation multiple that measures the market’s valuation of a company relative to its book value. The P/B ratio is only considered useful in practice when applied to capital-intensive businesses.
- EV/S. The Enterprise Value to Sales ratio is a valuation multiple that compares the enterprise value (EV) of a company to its revenues. The EV/S multiple gives investors a quantifiable metric of how to value a company based on its sales while taking into account both the company’s equity and debt.
- EV/EBITDA. The Enterprise Value to EBITDA ratio is a valuation multiple that compares the value of a company, debt included, to the company’s cash earnings less non-cash expenses. EBITDA can be misleading at times, especially for companies that are highly capital-intensive.
- EV/EBIT. The Enterprise Value to EBIT ratio is a valuation multiple that compares the value of a company, debt included, to the company’s earnings before interest and taxes (EBIT). Considered one of the most frequently used multiples for comparisons among companies, the EV/EBIT multiple relies on operating income as the core driver of valuation.
- EV/OCF. The Enterprise Value to Operating Cash Flow ratio is a valuation multiple that measures the value of a company, debt included, to the operating cash flow it generates.
- EV/FCFF. The Enterprise Value to Free Cash Flow to Firm ratio is a valuation multiple that compares the value of a company, debt included, to the amount of free cash flow available for all stakeholders. This metric is very similar to the EV/OCF but is considered a more exact measure, owing to the fact that it uses free cash flow, which subtracts capital expenditures (CapEx) from a company’s operating cash flow.
- EV/IC. The Enterprise Value to Invested Capital ratio is a valuation multiple that measures the dollars in Enterprise Value for each dollar of capital invested by shareholders and lenders.
Forward-Looking Multiples
A forward multiple is a version of a multiple that uses a forecasted variable for its calculation. For example, a forward P/E is a version of the P/E ratio that uses forecasted earnings for its calculation.
Multiples Benchmarks
To assess if a multiple is high or low, it must be compared to a benchmark. We provide historical values of the multiple, as well as its industry average, for this purpose.
Calculating Relative Value
Alpha Spread consolidates all the information about a company's valuation multiples into a single number called Relative Value. Our algorithm estimates a target multiple for each valuation metric and calculates the stock value accordingly. The average of these values is the relative value.
The quality of this valuation relies on the calculation of the target multiple. Our algorithm accounts for:
- Multiple’s historical values. It analyzes the historical distribution of multiple values to understand how a company has historically been valued.
- Growth prospects. A company with high expected growth should trade at a higher multiple than a company with lower expected growth. Our algorithm uses regression models to calculate the relationship between the multiple value and the expected growth.
- Industry multiple value. Our algorithm analyzes the multiple values of companies located in the same industry to increase the accuracy of the target multiple estimate.
The Bottom Line
Relative valuation is used to value companies by comparing them to other businesses based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E ratios. Alpha Spread takes into account all the information about the company’s valuation multiples and consolidates it into one single number – Relative Value.