PALAWAN STATE UNIVERSITY

College of Business and Accountancy

Department of Accountancy
Puerto Princesa City

MODULE 3:
Relative Valuation
PrE13: VALUATION CONCEPTS AND METHODS
Midyear | SY: 2020-2021

BSA 3

LARA CAMILLE C. CELESTIAL, CMA, CTT, CAP, CB

College of Business and Accountancy
Palawan State University
TABLE OF CONTENTS

Title Page of Module 1

Table of Contents 2

Overview 3
Learning Outcomes 3
Summary of Topics 3

Content
Topic 1: Relative Valuation 4
Topic 2: Relative Valuation Methods 7
2.1: Comparable Company Analysis 7
2.2: Precedent Transaction Analysis 9

References 11

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 MODULE 3 |
RELATIVE VALUATION
Overview
Relative Valuation is a type of business valuation method that
analyzes the value of a company to the value of its competitors or
industry peers in order to determine the financial worth of such a
company. It makes use of multiples, averages, ratios, and
benchmarks to determine a company's worth.

It is also used by investors to make informed decisions before

buying a company's stock. This model serves as an alternative to the
Absolute Value Model, which without taking a company's competitors
or industry peers into consideration, tries to analyze a company's real
value based on its estimated future cash flows discounted to their present value.

In this module, you will learn all you need to know about relative valuation, including its
benefits and drawbacks, as well as its methodologies.

Intended Learning Outcomes:

 Describe the Concept of Relative Valuation
 Differentiate relative valuation from intrinsic valuation
 Enumerate the two main types of relative valuation
 Discuss the most common kinds of relative valuation metrics
 Apply relative valuation metrics on problem-solving

Topics:
1: Relative Valuation
2: Relative Valuation Methods
2.1 Comparable Company Analysis
2.2 Precedent Transaction Analysis

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Topic #1: Relative Valuation Overview

Relative valuation, also referred to as comparable valuation, is a very useful and effective
tool in valuing an asset. Relative valuation involves the use of similar, comparable assets in
valuing another asset.

In the real estate market, relative valuation forms the framework for valuing a piece of real
estate. Anyone who has ever bought, sold, or had a reappraisal has seen this process at work.
Anytime real estate is valued, the valuation process always integrates the value of other nearby
properties that have been sold. From that starting point, the subject property is tweaked to
account for any difference before arriving at a final valuation.

There's an old business adage that says an asset is only worth what the next guy is willing
to pay for it. The painful truth of that reality hits home during economic meltdowns when sellers of
real estate get offers that are significantly below what their homes were originally being valued
at. The effectiveness of comparable valuation is that the process specifically relies on the value
of other assets that have been bought or sold.

A similar and effective approach can be utilized concerning stocks. A stock is a share
in a business and the fundamentals of the underlying business can be used to determine
the value of similar stocks.

Some of the most common and useful metrics to utilize in relative valuation include:
 Price-to-earnings ratio (P/E ratio) = Stock Price / Earnings Per Share
 Price to Cash Flow = Stock Price / Cash Flow per share
 Enterprise value (EV) = Market Capitalization + Net Debt
 EV to EBITDA ratio = Enterprise Value / EBITDA

Since no two assets are exactly the same, any relative valuation attempt should
incorporate differences accordingly. But first and foremost, you can't begin to apply
relative valuation effectively if you are dealing with apples and oranges. For example,
relative valuation may not be a good idea to use between McDonald's (MCD) and Darden
(DRI). While both are restaurant companies, McDonald's is a fast food concept while
Darden operates more formal sit-down concepts. Both are involved in the food business,
but they offer a different concept at different price points. As such, comparing margins
or another ratio would be ineffective since the business model is different.

The first step in ensuring an effective relative valuation is to make sure the two
businesses are as similar as possible.

For instance: Visa VS MasterCard

Visa (V) and MasterCard (MA) are the two most well-known branded credit card names in the
world. Since both operate similar business models, a relative valuation for both would be an
effective exercise. Looking at both companies in the summer of 2011, Visa shares trade for $85
while MasterCard shares fetch $304. Visa has a market cap of over $60 billion while MasterCard

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has a market cap of $38 billion. On their own, those numbers don't tell us much except that Visa
is a bigger company than MasterCard. Here are the following relative valuation metrics:

Numbers are rounded for simplicity. Someone comparing the P/E ratios of Visa and
MasterCard may conclude that Visa is a better value because of a lower P/E. However, relatively
comparing various other metrics may suggest otherwise. Despite a lower operating margin,
MasterCard has a significantly higher return on equity on an unlevered balance sheet. Also
relative to its market cap, MA churns more cash flow per share than Visa. If MasterCard can
continue pulling in the free cash flow at similar levels, then it's clearly creating more value
from shareholders.

While investors often rely on market cap to determine ratios, enterprise value may be a more
effective tool. Simply defined: Enterprise Value = Market Cap + Debt – Cash

A company with loads of debt relative to cash will have an EV that is significantly higher
than its market cap. That's important because a company with a market cap of a $1,000 and a
profit of $100 will have a P/E of 10. If that company has $500 in net debt on the balance sheet,
its EV is $1,500, and its debt-adjusted P/E, or EV/E, is 15. We are looking at enterprise values
to earnings here for simplicity. Normally enterprise value should be compared to EBITDA.

Another useful metric in relative valuation, return on equity, and increases as a company
take on more debt. Without looking at the balance sheet an investor may conclude that company
A with an ROE of 30% is more attractive than company B with an ROE of 20%. But if company
A has a debt to equity ratio of two while company A is debt-free, the 20% unlevered return on
equity may be much more attractive.

What the comprehensive relative valuation process ultimately does is help prevent
investors from anchoring their decisions based on one or two variables. While value investors
love to buy stocks with low P/E ratios, that alone may not be effective. Consider Chipotle
Mexican Grill (CMG). Even during the recession, shares were trading for around 25 times
earnings when other restaurants were trading of 10–15 times earnings. But further comparison
justified Chipotle's P/E ratio: its margins were higher and it was growing its profits by leaps and
bounds while the balance sheet remained healthy. Chipotle shares soared nearly 200% in the
two years following the Great Recession.

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 "When using a relative valuation metric, such as the price-to-earnings ratio, if you use a
slightly incorrect assumption, you are likely to miss the valuation estimate by a substantial
amount," said David Krause, Director of the Applied Investment Management program at
Marquette University. "Relative valuation approaches tend to be quick and simple to use;
however, they can lead to highly misleading results. It is best to use a variety of valuation
methods and to triangulate the results using multiple approaches."

Benefits
The main advantage of relative valuation, especially for beginners in the world of stock
investing, is its simplicity. The calculation of the ratios usually consists simply of a simple
arithmetic operation, usually a division, without going into the complexity of the calculation of
the cash flow discount. As such, relative valuation is often the most widely used valuation
method, especially among beginning investors.

However, although relative valuation is simple in its calculation, this does not mean that
we are dealing with a valuation method with limited resources, but rather that another advantage
of relative valuation is its adaptability. As I have already told you, there is no limited number of
ratios, so we can create new ratios to compare companies in a more precise way. For example,
to value telecommunications companies it is common to use a ratio of profit per customer to
calculate their efficiency.

Limitations
The main problem with relative valuation is that it can sometimes be misleading. We all
remember the housing and credit bubble experienced relatively recently in Spain, the United
States, and many Western countries. During that time, both banks and construction and real
estate companies did not seem to be trading at exorbitant prices in terms of their relative value.
However, they were if we considered that we were inside a bubble, something that only the most
experienced analysts and investors realized. Therefore, one must be careful with the limitations
of relative valuation to detect business cycles.

In addition, when we use relative valuation to determine if we want to invest in a certain

company, the companies must be comparable. For example, a company that trades a low PER
(price / earnings ratio) may be cheaper than one that trades at a higher PER, which in theory
would mean that it is more expensive. This may be because the company with a high PER has
very good growth expectations, while the company with a low PER may be in decline.

Bottom line
Like other valuation techniques, relative valuation has its benefits and limitations. The
key is to focus on the metrics that matter most and understand what they convey. But despite
those limitations, relative valuation is a very important tool used by many market professionals
and analysts alike.

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Topic #2: Relative Valuation Models

There are two common types of relative valuation models: comparable company analysis and
precedent transactions analysis. Below is a detailed explanation of each method:
a) Comparable Company Analysis
b) Precedent Transaction Analysis

SIMILARITIES:
 Relative valuation
 Use multiples (EV/Revenue, EV/EBITDA)
 Hard to find perfectly comparable companies
 Shows what a presumably rational investor/acquirer is willing to pay (observable)

DIFFERENCES:
 Takeover premium (included in precedents – not in comps)
 Timing (precedents quickly become old– comps are current)
 Available information (difficult to find for precedents– readily available for comps)

Both methods are a form of relative valuation, where the company in question is being compared
to other businesses to derive its value. However, “comps” are current multiples that can be
observed in the public markets, while “precedents” include a takeover premium and took place
in the past.

2.1 COMPARABLE COMPANY ANALYSIS

Comparable company analysis (or “comps” for short) is a valuation methodology that
looks at ratios of similar public companies and uses them to derive the value of another
business. Comps is a relative form of valuation, unlike a discounted cash flow (DCF) analysis,
which is an intrinsic form of valuation.

The following are the steps in performing comparable analysis:

1. Find the right comparable companies
This is the first and probably the hardest (or most subjective) step in performing a ratio
analysis of public companies. The very first thing an analyst should do is look up the company
you are trying to value on CapIQ or Bloomberg so you can get a detailed description and industry
classification of the business.

The next step is to search either of those databases for companies that operate in the
same industry and that have similar characteristics. The closer the match, the better.
The analyst will run a screen based on criteria that include:
 Industry classification
 Geography
 Size (revenue, assets, employees)
 Growth rate
 Margins and profitability

2. Gather financial information

Once you’ve found the list of companies that you feel are most relevant to the company
you’re trying to value it’s time to gather their financial information. Once again, you will probably

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be working with Bloomberg Terminal or Capital IQ and you can easily use either of them to
import financial information directly into Excel.

The information you need will vary widely by industry and the company’s stage in the
business lifecycle. For mature businesses, you will look at metrics like EBITDA and EPS, but
for earlier stage companies you may look at Gross Profit or Revenue. If you don’t have access
to an expensive tool like Bloomberg or Capital IQ you can manually gather this information from
annual and quarterly reports, but it will be much more time-consuming.

3. Set up the comps table

In Excel, you now need to create a table that lists all the relevant information about the
companies you’re going to analyze.
The main information in comparable company analysis includes:
 Company name
 Share price
 Market capitalization
 Net debt
 Enterprise value
 Revenue
 EBITDA
 EPS
 Analyst estimates

4. Calculate the comparable ratios

With a combination of historical financials and analyst estimates populated in the comps
table, it’s time to start calculating the various ratios that will be used to value the company in
question. The main ratios included in a comparable company analysis are:
 EV/Revenue
 EV/Gross Profit
 EV/EBITDA
 P/E
 P/NAV
 P/B

5. Use the multiples from the comparable companies to value the company in question
Analysts will typically take the average or median of the comparable companies’ multiples
and then apply them to the revenue, gross profit, EBITDA, net income, or whatever metrics they
included in the comps table.

In order to come up with a meaningful average, they often remove or exclude outliers
and continually massage the numbers until they seem relevant and realistic.

For example, if the average P/E ratio of the group of comparable companies is 12.5 times,
then the analyst will multiply the earnings of the company they are trying to value by 12.5 times
to arrive at their equity value.

6. Interpreting the Results

Once the numbers are complete and the comps table is finalized, it’s time to start
interpreting the results. One way to use the information is to look for companies that are
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overvalued or undervalued. Comps can help you uncover the opportunities, but the results need
to be interpreted carefully as they don’t include any qualitative factors whatsoever.
To properly evaluate the numbers in the comps table you have to
understand why numbers are what they are. Why does Company A trade at a discounted
EV/EBITDA multiple to Company B? Is it because it’s undervalued and a good buying
opportunity? Or, is it because it has a much lower growth rate and requires more CapEx
spending? Even though Company A trades at a lower multiple, it might actually be “more
expensive” than Company B!

This is where the art of being a great financial analyst comes into play.

Applications of Comparable Company Analysis

There are many uses for comps (or comparable companies analysis, or market multiples,
or whatever name you use for them). Typically performed by financial analysts and associates,
the most common uses include:
 Initial Public Offerings (IPOs)
 Follow-on offerings
 M&A advisory
 Fairness opinions
 Restructuring
 Share buybacks

2.2 PRECEDENT TRANSACTION ANALYSIS

Precedent transaction analysis is a method of company valuation where past M&A
transactions are used to value a comparable business today. Commonly referred to as
“precedents,” this method of valuation is common when trying to value an entire business as
part of a merger/acquisition.

The following are the steps in performing precedent analysis:

1. Search for relevant transactions
The process begins by looking for other transactions that have happened in (ideally)
recent history and are in the same industry.
The screening process requires setting criteria such as:
 Industry classification
 Type of company (public, private, etc.)
 Financial metrics (revenue, EBITDA, net income)
 Geography (headquarters, revenue mix, customer mix, employees)
 Company size (revenue, employees, locations)
 Product mix (the more similar to the company in question, the better)
 Type of buyer (private equity, strategic/competitor, public/private)
 Deal size (value)
 Valuation (multiple paid, i.e., EV/Revenue, EV/EBITDA, etc.)

The above criteria can be set in a financial database, such as Bloomberg or CapIQ, and
exported to Excel for further analysis.

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2. Analyze and refine the available transactions
Once the initial screen has been performed and the data is transferred into Excel, then
it’s time to start filtering out the transactions that don’t fit the current situation.

In order to sort and filter the transactions, an analyst has to “scrub” the transactions by
carefully reading the business descriptions of the companies on the list and removing any that
aren’t a close enough fit.

Many of the transactions would have missing and limited information if the deal terms
were not publicly disclosed. The analyst will search high and low for a press release, equity
research report, or another source that contains deal metrics. If nothing can be found, those
companies will be removed from the list.

3. Determine a range of valuation multiples

When a shortlist is prepared (following steps 1 and 2), the average, or selected range, of
valuation multiples can be calculated.

The most common multiples for precedent transaction analysis are EV/EBITDA and
EV/Revenue. An analyst may exclude any extreme outliers, such as transactions that had
EV/EBITDA multiples much lower or much higher than the average (assuming there is a good
justification for doing so).
4. Apply the valuation multiples to the company in question
After a range of valuation multiples from past transactions has been determined, those
ratios can be applied to the financial metrics of the company in question.

For example, if the valuation range was:

 4.5x EV/EBITDA (low)
 6.0x EV/EBITDA (high)

And the company in question has an EBITDA of $150 million,

The valuation ranges for the business would be:

 $675 million (low)
 $900 million (high)

When to use relative valuation?

Relative valuation can be used in most cases since its adaptability means that it can be
adapted to almost any type of company. However, it is necessary that if we are going
to carry out a valuation using the relative valuation method, we take into account its
limitations and only use it with comparable companies and taking into account
economic cycles.

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REFERENCES|
https://bookshelf.vitalsource.com/#/books/9781119518877/cfi/6/38!/4/2/28/22@0:71.7

https://divergentview.com/investment_guide/relative-valuation/

https://ourparishcouncil.org/relative-valuation-concept-advantages-and-disadvantages/

https://corporatefinanceinstitute.com/resources/knowledge/valuation/comparable-
company-analysis/

https://corporatefinanceinstitute.com/resources/knowledge/valuation/precedent-
transaction-analysis/

https://www.investopedia.com/terms/r/relative-valuation-model.asp

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