The PE ratio (price to earnings ratio) of a company is 20. Then, you may be wondering if that company’s share price is cheap or expensive? The short answer to this is – “Well, it depends on few things, or in fact on many things”. This typical answer is defined as ‘relative valuation’.
According to studies, relative valuation accounts for around 85% of equities research analysts’ valuations and 50% of corporate M&A transactions. So, what precisely represents the relative valuation? It is the practice of estimating a stock’s fair value based on how it is valued in relation to a variety of elements. So, whether a stock’s PE is 15, 25, or 35, the only method to determine if it is cheap or expensive is to compare this single figure to its prospects for growth, competitor business multiples, sector pricing range, historical mean PE, current interest rates, and so on.
Stock market professionals and many prominent fund managers across the world feel that quantitative valuation (such as the DCF technique) is the superior way to determine the worth of a stock. However, due to the challenges involved in developing suitable models, inadequate data, time limitations, and the fact that there are several hundred stocks to consider, it is simply not possible to conduct a DCF (discounted cash flow model) for all of your equity investments, and thus relative valuation as a method of selecting stocks is commonly employed and accepted in the investing marketplace. When you purchase or sell a stock based on its PE, P/B, EV/EBITDA, or any other multiple, you are engaged in relative valuation.
In relative valuation, the more broadly you examine the value of the asset, that is, when you compare the valuation multiple to more characteristics, the better your viewpoint.
As per the definition of relative valuation, each number is the consequence of dividing ‘A’ by ‘B’. For example, the PE ratio is the stock price divided by its earnings. All of these ratios are used to gauge the stock to comparable metrics from other stocks and evaluate its advantages. Before we begin utilizing comparable valuation to choose companies, it is vital to note that relative valuation may be done using either equity multiples or enterprise multiples.
First let us see what are ‘Equity Multiples’:
If you look at any company’s balance sheet, the liabilities section is generally made up of two line items: shareholder funds and borrowings. On the contrary, a profit and loss statement begins with revenue, then moves on to variable expenses, fixed costs, depreciation, interest costs and taxes. Equity stockholders’ only entitlement to distribution or allocation between themselves is what remains after taxes are paid. This line item in the P&L statement is known as ‘Profit after tax’ or simply ‘Net profit’. So, if you’re performing relative valuation based on equity multiples, be sure to divide the equity – i.e. price per share of the firm by the line items that pertain to equity owners.
There are three items that may be assigned to equity shareholders, which are: net profit from the profit and loss statement, book value or shareholder funds from the balance sheet, and free cash flows to equity (FCFE) from the cash flow statement. Any relative valuation multiple will be associated with one or more of these three items.
Using this method of valuation, it may seem that pricing based on sales or EBITDA is inappropriate. Let us assume, Companies A and B have the same market cap of Rs. 100 and are equal in other aspects except debt levels, making it difficult to distinguish between them. Let us even consider that ‘A’ and ‘B’ both have same revenue of Rs. 100 and same EBITDA of Rs. 30. But A has zero debt, while B has debt of Rs. 20. As revenue and EBITDA are the same for both the companies, if you do a market cap/revenue or marketcap/EBITDA, both companies will have the same valuation, which does not present the correct picture, because one company is debt-free, while the other has some debt, and thus some interest cost must be borne by the company ‘B’ for that debt.
Let’s assume depreciation is Rs. 10, and taxes are Rs. 5 for both the companies. But interest cost of ‘B’ is 10 per cent. This means the Net profit of A is Rs. 15, while that of B is Rs. 13. As a result, while both businesses have comparable Price/Revenue and Price/EBITDA ratios, ‘A’ has a lower PE ratio – i.e., PE ratio of ‘A’ is 6.7 and PE ratio of ‘B’ is 7.7. Hence on a relative value basis, you must select ‘A’ above ‘B’, but you probably wouldn’t have seen it if you had chosen the wrong metrics to value.
As a result, selecting the appropriate multiples is critical. When it comes to equity measurements, the numerator must always be price or market capitalization divided by line items from the profit and loss statement that corresponds to holders of equity.
Now ‘Enterprise Value’ Metrics:
Enterprise value (EV) is the whole value of a firm or enterprise. The market’s perception of overall worth is expressed by the sum of market capitalization and net debt (which includes minority stake as well). What applies to the case of EV is that, the overall worth of a firm remains same regardless of whether it is funded entirely by equity or through a mix of equity and debt. Using EV, the value of equity (stock price) is calculated from the value of the enterprise. Because organizations’ capital structures vary greatly, an EV method allows them to be valued on comparable terms. To calculate the equity value, start with the company’s value and then deduct the net debt. The advantage of EV-based measures is that they provide additional possibilities for valuing a firm.
However, it is important to note that valuation accuracy improves as we move down the P&L and cash flow statement. That is, there are instances when a company’s earnings are low but its operational performance, i.e. EBITDA, is not poor. In such circumstances, when sales and EBITDA expand, operating leverage causes PE to grow significantly faster than the other two line items.
Hence when equity-based valuation multiples fail to provide a clear picture, EV-based indicators can be considered. Where even EBITDA multiples are unclear, as was the case with several new-age firm IPOs that reported losses at the EBITDA level, investors are forced to go farther up the P&L to measures like EV/revenue, or even outside of the P&L to the metrics such as EV/subscriber. So, when comparing firms and investing in them based on EV/Subscriber, there must be an appealing narrative supporting the subscriber base’s potential monetization in the future in a lucrative manner. However, investors need to keep in mind that risk factors are greater, as are the potential rewards.
Another consideration when it comes to EV-based valuation is that any change in EV will solely affect the equity value. For example, if a company’s EV is Rs. 200 and it has Rs. 75 in debt, the equity value is Rs. 125. In this scenario, if you believe EV would rise by 10% (provided no change in debt level of the company), the value of equity will increase by 16%, and the opposite is also true. The higher the leverage, the greater the impact of EV changes on the stock’s value (both up and down).
How to make relative valuation reasonable?
Given that relative valuation is dependent on comparisons to peer multiples, investors must take steps to ensure that the reference multiples are appropriate as well. An inflated competitor business can’t be used to explain high valuations in a single stock. For instance, if two bottles of ketchup cost twice as much as one, the market is considered efficient. But the problem is that it ignores the question of whether a single bottle of ketchup is reasonably priced. This is essentially the primary point underlying the 2007 US housing bubble, which caused the global financial crisis. Before buying a property during the boom, consumers closely compared prices to ‘prices of other houses’, but neglected to consider if the overall home price is reasonable or not.
So, to avoid errors when using relative valuation to analyze businesses, you may add levels of comparison by examining how their valuation compares to growth potential. Aside from this, there are several more considerations that might justify varying prices. Essentially, equity values do not operate in a vacuum. Investors have a variety of alternatives, including fixed deposits, bonds, and real estate. When alternative assets become more appealing, one must consider the potential for value shift in equities as well.
With consistency and experience, investors’ relative valuation process will improve.
