Euromoney Institutional Investor PLC
A Conceptual Framework for Relative Valuation
Author(s): Manu Sharma and Esha Prashar
Source: The Journal of Private Equity, Vol. 16, No. 3 (SUMMER 2013), pp. 29-32
Published by: Euromoney Institutional Investor PLC
Stable URL: https://www.jstor.org/stable/43503771
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A Conceptual Framework
for Relative Valuation
Manu Sharma and Esha Prashar
Manu Sharma
is an assistant professor at
published on relative valuathe University Institute of
tion but found nothing conApplied Management SciWe published tion crete. searched but Manycrete.foundManyonartiarti
cles analcleyszefor relative nothing literature analyze valua- conences (UIAMS), Panjab
equity valuation, but a detailed study on relaUniversity in Chandigarh,
India.
tive valuation could not be found anywhere.
manumba2000@yahoo.com
Among the first studies, Penman [1997] discussed applying the multipliers to earnings
Esha Prashar
and
book value to calculate equity values. He
is an MBA student at
assi
g
ned weights to price/earnings (P/E) and
the University Institute
pri
c
e/book
multiples to make the valuations
of Applied Management Sciences (UIAMS),
more authentic. Zhang [1999] discussed the
Panjab University
accounting-based valuation model, wherein
in Chandigarh, India.
companies have the flexibility to expand or
eshaprashar@yahoo.com
discontinue operations. He explored the crosssectional differences in the behavior of the
value multiples. The forward-looking multiples (P/E multiples) outperform the trailing
multiples. Fernandez [2013] found the valuations performed using multiples to be highly
debatable, because the multiples showed broad
dispersions. He found the multiples to be
useful in the second stage of valuation, however, wherein an assessment with the multiples
of comparable companies helped to identify
the difference between the company that was
valued and the comparable company.
Comparable Company
Analysis
Relative valuation is the valuation of
valuation function and found that accountingassets based on how similar assets are priced
earnings and the book value of equity play ain the market by using such indicators as P/E,
considerable role.
P/E-to-growth (PEG) ratios, enterprise mul-
Liu et al. [2000] analyzed the valua- tiples, and so on. It helps to unearth the low-
tion performance for pricing multiples and priced companies with strong fundamentals.
found that the stock prices for most compa- Once the target company is selected, the relanies could be well ascertained from the multive valuation of the comparable company can
tiples derived from forward earnings. Abukari be calculated.
et al. [2000] explored using earnings, book
To analyze our comparable companies,
value, and dividends as important factors in we create a list of comparable companies;
an equity valuation model. They found the obtain key financial information; find ratios,
most important variables to be book value andbusiness statistics, and trading multiples; benchthe earning-related variables, along with the mark comparable companies; and determine
dividend levels that helped the company to valuation.
perform better in the market.
Schreiner and Spremann [2007] found
that equity value multiples outperform entity
Summer 2013 The Journal of Private Equity 29
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CREATING A LIST OF COMPARABLE
COMPANIES
different companies in different geographical regions
differ.
Distribution channels. Distribution channels are
Once the target company is selected, it becomes
easy through which a company sells its products
the channels
to find the universe of comparable companies.
Compa-to end users. Companies that sell only to
and services
nies with similar business profiles, financial data,
sectors,
wholesale
markets will have a different pattern of sales
products, and services should be selected as from
comparables.
that of retailers or end users.
A broad group of comparables is selected at the initial
level, and the list is then narrowed down based on simiFinancial Profile
larity with the target company.
For the sake of comparison, the main characterisThe key financial characteristics of a company also
tics of the target company can be selected based
the
help inon
determining
the target company and comparable
following criteria: the business profile - sector,
end
marcompanies.
kets and customers, products and services, geography,
Size. The size of a company can be measured using
and distribution channels - and the financial
profile
its financial statistics
or market valuation. Companies of
size, return on investment (ROI), growth pattern,
similar size and
tend to have similar financiais and serve as
profitability.
Business Profile
good comparables. Financials such as earnings before
interest and taxes (EBIT), earnings before interest, taxes,
depreciation, and amortization (EBITDA), gross profit,
enterprise value, and so on can be compared.
Companies with similar business characteristics act ROI. ROI refers to the amount of earnings a
as good comparables. Similar sectors, end markets and
company can provide to its capital providers. The most
customers, products and services, geography, and distribucommon calculations used to determine ROI are return
tion channels serve as the basis for good comparables.
on invested capital (ROIC), return on equity (ROE),
Sector. Sector can be defined as the industry in
and return on assets (ROA). Dividend yield is also used
which a company operates. To expand the purview
of
to determine
shareholder earnings for a given company.
finding comparables, sector can be divided into subsectors.
Comparable companies will have a similar return pattern
For companies having separate subdivisions, the valuation
during a given time period.
is done divisionwise. The risks and returns faced by Growth pattern. A company's growth pattern can
companies in the same sector exhibit similar trends.be evaluated by studying the past and estimated future
End markets and customers. An end market is
financial performance. Generally, the earnings per share
the place where the company's product is sold. Companies
(EPS) or EBITDA values of companies are taken for the
catering to the same end markets share similar performance
purpose of comparison in determining the comparable
patterns, as they are affected by the same macroeconomic
companies.
factors. Customers are the people who purchase the Profitability. A company earns profits if it is able
products and services of a company. Companies may have
to convert its sales into profits. Generally, the profitsa specific target market or a diversified customer base.
to-sales, EBITDA-to-sales, and EBIT-to-sales ratios are
Thus, this helps the companies to find similar trends calculated
and
to determine the profitability of a company.
opportunities.
Companies in the same sector share a similar profitability
Products and services. A company is identified
pattern and are thus good comparables.
by the products and servîtes it offers to the customers.
A company may provide only products, only services, or
OBTAINING KEY FINANCIAL
both. Companies that offer similar products and services
INFORMATION
serve as good comparables.
Geography. Geographical factors often dis-
Financial information can be based on either his-
tinguish companies on the basis of their fundamentals,
torical information or expected future performance.
characteristics, macroeconomic factors, growth rates,
Financial information can be obtained through U.S.
opportunities, risks, and so on. Thus, the valuation Securities
of
and Exchange Commission (SEC) filings,
30 A Conceptual Framework for Relative Valuation Summer 2013
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which include annual, quarterly, and current reports that
provide insight into a company's historical data. This
information can be further used to determine historical
net income, EBIT, EBITDA, net sales, cash balances,
depreciation, amortization, equity, and debt, which provide a detailed analysis about a company's financiais.
To study expected future performance, equity
to the size, sector, and subsectors of the given universe
of companies.
DETERMINING VALUATION
An appropriate valuation range for the target
pany can be derived by studying the trading multi
research reports are useful. These reports include esti-
the comparable companies. Identical assets can be
mates for sales, EBIT, and EPS for future quarters. Details
pared by using the prices of these assets, but to value
regarding any mergers and acquisitions can be gleaned
by examining press releases or the company's website.
After evaluating the financiais for different companies,
the closest comparables can be nailed down.
companies in the market, a common variable some
needs to be found in order to standardize the values for
the sake of comparison. Values are generally standardized
based on earnings, revenues, or book value in a particular
sector. Various multiples can be used.
FINDING RATIOS, BUSINESS STATISTICS,
AND TRADING MULTIPLES
Revenue Multiple
The revenue multiple help in determining a ratio
Once the financiais for the comparable companies
of the
value of the business to the revenue it generates.
are determined, the next step is to locate the
essential
It is value
also known
ratios and trading multiples. Herein, the equity
of as the price-to-sales ratio. Using the
an asset or the value of the asset itself can be standardized
revenue multiple makes it easier to compare companies
using any of the formulas for P/E, value/EBIT, value/ in different sectors. It varies significantly in every sector,
EBITDA, P/B, value/book value of assets, and so on.
however, as profit margins vary from sector to sector.
If we compare the equity value of a company with
that of other companies in the same sector, it provides
Earnings Multiple
a measure of only the relative size of the company. To
The earnings multiple shows the earnings that an
determine relative market performance, the current share
price of the company with respect to the 52-week high asset generates. An investor generally thinks about the
price should be checked. The enterprise value - the sum price that will have to be paid as a multiple of the earnings
of equity, debt, and preferred stock less cash and cash per share that the company will generate. Hence, P/E is
equivalents - also helps in determining the value of com- calculated. The value of a company must also be examparable companies. Similar companies tend to have similar ined with respect to EBITDA and operating income.
enterprise value multiples, despite any differences in their
capital structure.
Book Value Multiple
BENCHMARKING COMPARABLE
COMPANIES
The book value multiple provides an accounting
estimate of the value of the business that differs from
that of the financial markets. The accounting estimates
of book value
After selecting the comparable companies
and is based on basic accounting rules that
take
into consideration the price at which the asset was
obtaining their ratios, statistics, and trading
multiples,
the next important step is to benchmark the
purchased,
companies.
adjustments for depreciation, and so on. P/B
First, the target company and its comparables
helps
need
an investor
to be to determine whether a stock is over- or
benchmarked based on their financial information. The
undervalued. This ratio may vary significantly depending
on the sector, as the assets required in each sector differ
growth pattern, profitability, and size of the company
from each other.
should be compared with the target company. Second,
When using these multiples, the following points
the trading multiples for the peer group with respect
should be kept in mind:
to the closest comparables need to be analyzed. This
helps to determine the closest comparables according
Summer 2013 The Journal of Private Equity 31
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• The multiples must be defined consistently and
measured uniformly for all the companies that are
being compared.
• The cross-sectional distribution of multiples should
be carefully analyzed, not only in a given sector
but also for the entire market.
they perform on a relative basis (to the market and other
money managers), relative valuation is more tailored
to their needs. And finally, relative valuation generally
requires less information than discounted cash flow valuation (especially when multiples are used as screens).
One disadvantage is that a portfolio composed of
• The fundamental factors that determine a multiple stocks that are undervalued on a relative basis may still be
should be properly analyzed and understood, as overvalued, even if the analysts' judgments are correct. It
should how the changes in the fundamental factors is just less overvalued than other securities in the market.
Another disadvantage is that relative valuation is built on
bring about a change in the multiples.
• Proper companies should be used for the purposes the assumption that markets are correct in the aggregate,
of the comparison, and any differences that may even though it makes mistakes about individual securities. To the degree that markets can be over- or underexist among the companies must be controlled.
valued in the aggregate, relative valuation will fail.
Relative valuation may require less information in
ADVANTAGES AND DISADVANTAGES
OF RELATIVE VALUATION
the way in which most analysts and portfolio managers use
it. However, this is because implicit assumptions are made
other variables (which would have been required
Compared with discounted cash flowabout
valuation,
in a discounted
relative valuation is much more likely to reflect
marketcash flow valuation). To the extent that
these implicit
perception and investor sentiment. Its advantages
areassumptions are wrong, the relative valuawill also
wrong. It is also difficult to find similar
many, including when the objective of the tion
investor
isbeto
assets,
no two assets can be exactly similar.
sell a security at that price on a given day (as
in because
the case
of an IPO) and when investing with momentum-based
strategies. In addition, relative valuation will always provide a list of securities that are under- and overvalued.
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32 A Conceptual Framework for Relative Valuation Summer 2013
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