Definition, Steps, and Types of Models

What Is a Relative Valuation Model?

A relative valuation model is a financial tool for comparing a company’s value to that of similar companies. Rather than valuing a business on its own internal metrics, this approach asks: How does the company stack up against its peers or industry averages? 

By examining market valuations of comparable firms, analysts can gauge whether a stock appears overvalued, undervalued, or fairly priced relative to others in its field. This provides market-based context for making investment decisions.

Definition of Relative Valuation Model

A relative valuation model estimates a company’s worth by comparing it to other companies’. It uses financial ratios or multiples of similar businesses to judge the company’s value. The idea is that companies with similar operations should trade at similar multiples.

If one company’s metrics, such as its price-to-earnings ratio, are out of line with those of its peers, it could indicate that the stock is mispriced. For example, if peers trade around 10x earnings and one company trades at 5x, that company looks undervalued relative to the group. Relative valuation models, therefore, rely on peer valuations, rather than on intrinsic value calculations.

Bridger Pennington, co-founder of Fund Launch, emphasizes: “Valuation isn’t done in isolation; it’s guided by how similar companies are trading.”

Comparison with Absolute Valuation Models

Absolute valuation calculates intrinsic value based on a company’s future cash flows, without referencing market comparisons. Common methods include discounted cash flow (DCF) analysis. In contrast, relative valuation focuses on current market prices of comparable companies to evaluate a stock’s worth.

Pennington highlights this difference clearly: “Absolute valuation is about what a company is fundamentally worth; relative valuation is about what others are willing to pay.”

Analysts typically use both methods. Absolute valuation provides foundational value, while relative valuation confirms this through market data. Together, they offer a more comprehensive understanding of a company’s worth.

Key Metrics and Ratios Used in Relative Valuation

Analysts use several key valuation multiples to compare companies. The choice of metric depends on the industry and what drives value. Common ratios include:

Price-to-Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio is calculated by dividing a stock’s price by its earnings per share. It shows how much investors are paying for each dollar of earnings. In a relative valuation, a company’s P/E is compared to those of other companies. 

A higher P/E than peers indicates the stock is potentially overvalued, while a lower P/E suggests it’s potentially undervalued. For example, if the average P/E in an industry is 15 and Company A’s P/E is 8, Company A looks undervalued compared to its peers.

Enterprise Value (EV) Ratios

Enterprise value (EV) represents the total value of a company (equity plus debt minus cash). A common EV-based metric is EV/EBITDA, which divides enterprise value by earnings before interest, taxes, depreciation, and amortization. 

This ratio allows comparison of companies regardless of their capital structure, since it factors in debt and uses a pre-interest earnings measure. If one company’s EV/EBITDA is lower than those of similar companies, it may be undervalued on this basis. 

Analysts also use EV/Sales (enterprise value to sales) for situations where earnings are negative or not meaningful, such as early-stage companies.

Other Common Ratios

Other multiples are used depending on the industry:

• Price-to-Sales (P/S): Market capitalization divided by annual sales. Often used for companies without profits (e.g., early-stage tech), as it focuses on revenue. A low P/S relative to peers could indicate an undervalued stock.
• Price-to-Cash-Flow: Stock price divided by cash flow per share (operating or free cash flow). Useful for firms where cash flow diverges from net income (e.g., companies with heavy non-cash charges). A low P/CF relative to peers suggests the stock may be undervalued.

Each sector tends to have favored metrics. For instance, banks often use price-to-book value, while telecom and utility companies might emphasize EV/EBITDA. The key is selecting ratios that best capture how investors value companies in that particular sector.

Steps in Conducting a Relative Valuation

Here are the necessary steps to conduct a relative valuation:

• Identify Comparable Companies: First, identify comparable companies (“comps”) in the same industry with similar size and business models. The idea is to compare the target company to peers that mirror its operations as closely as possible. The analysis is only as good as the peers chosen. Pennington notes, “If your comparables aren’t truly comparable, the multiples can mislead you.”
• Select Relevant Ratios: Next, choose the valuation ratios that fit the company and industry. Different industries focus on different metrics. For example, you might use P/E and dividend yield for a utility company, but rely on P/S or user-based metrics for a high-growth tech startup that has little or no earnings. The goal is to use measures that reflect what investors care about for that type of business. As Pennington says, “Every industry has its key metrics—you wouldn’t value a new software firm on P/E alone.”
• Calculate and Compare Ratios: Then, calculate the selected ratios for the target and each peer, and compare the results. If the target’s ratios are higher than its peers’, its stock is relatively expensive; if lower, it’s relatively cheap. If most peers trade around 10x earnings, and the target is at 8x, it appears undervalued by that metric.

  It’s important to consider why the discrepancy exists: a low multiple might indicate an opportunity, or it could be a reflection of company-specific issues. This comparative step reveals where the company stands in the context of its peers in the market.

Types of Relative Valuation Models

Market Multiple Models

These models apply an average market multiple from comparable companies to the target’s financial results to estimate its value. For example, let’s say comparable firms trade at an average of 5× sales, and the target company has $200 million in sales. In this scenario, a market multiple approach would suggest a valuation of about $1 billion (5 × $200M) for the target’s equity. 

Market multiple models are straightforward to use and tie the valuation directly to prevailing market benchmarks. The key is ensuring the multiple used is representative of the peer group and not skewed by outliers.

Comparable Company Analysis

Comparable company analysis (CCA) involves a side-by-side comparison of key multiples for a group of similar companies to see where the target falls. This provides a nuanced view of valuations, showing the range among peers rather than a single average. Using this information, the analyst can estimate a fair value range for the target. If most peers trade between 8× and 10× EBITDA, the target will likely fall in that band, barring unique factors.

Precedent Transactions Analysis

This approach examines valuation multiples from past acquisition deals involving similar companies. By looking at what acquirers paid—say, that several recent buyouts in the industry happened around 12× EBITDA—an analyst can gauge what the target might be worth in a takeover scenario. 

Precedent transaction multiples typically include a control premium (buyers pay extra to control the company), so they often come out higher than everyday trading multiples. This analysis is especially useful in mergers and acquisitions to establish an upper bound of value based on real-world transaction data.

Advantages and Limitations of Relative Valuation Models

Advantages

• Simplicity: Easy and quick to perform with readily available data, unlike complex intrinsic valuation models that require many assumptions.
• Market Relevant: Reflects current market sentiment and industry trends by using actual pricing of comparable businesses.
• Comparative Insight: Highlights whether a stock is trading at a premium or discount to its peers, helping identify potential overpricing or underpricing.
• Benchmarking: Serves as a market-based check. It can validate or flag discrepancies when compared against valuations derived from other methods (like a DCF model).

Disadvantages

• Market Mispricing: If an entire sector is mispriced, a relative valuation will reflect that. Pennington cautions that “being ‘cheap’ relative to overpriced peers doesn’t guarantee a bargain.”
• Lack of True Comparables: It’s often hard to find identical comparables. Companies can differ in size, growth, or accounting, which can skew the analysis.
• Limited Perspective: Relative models give a snapshot based on current data. They don’t account for a company’s future prospects or risks. A stock might look undervalued versus peers but still be a poor investment if its outlook is weak, and the reverse can also hold true.

The Bottom Line

Relative valuation models offer a quick, market-driven way to gauge a company’s value relative to peers, and they are popular for their simplicity and insights. However, investors should be careful not to rely on relative analysis alone. The best approach is to use relative valuation alongside absolute methods, combining market perspective with fundamental analysis to make well-informed decisions. Considering both relative and absolute valuations helps investors gain a more complete picture of a stock’s worth.