Relative Valuation
Relative valuation compares a company to similar companies using valuation multiples. It's faster and often more practical than DCF.
Relative valuation answers: "Is this stock cheap or expensive compared to peers?" It's the most commonly used valuation approach.
How It Works
- Find comparable companies
- Calculate valuation multiples for peers
- Apply those multiples to your company
- Determine if cheap or expensive
Common Multiples
Price-to-Earnings (P/E)
P/E = Stock Price / Earnings Per Share
| P/E Level | Interpretation |
|---|---|
| Higher than peers | May be overvalued |
Price-to-Book (P/B)
P/B = Stock Price / Book Value Per Share
Best for:
- Banks and financials
- Asset-heavy companies
- Companies with negative earnings
EV/EBITDA
EV/EBITDA = Enterprise Value / EBITDA
Advantages:
- Accounts for debt
- Before depreciation differences
- Capital structure neutral
EV/EBITDA is often better than P/E because it's not affected by capital structure differences between companies.
Price-to-Sales (P/S)
P/S = Market Cap / Revenue
| Use Case | When |
|---|---|
| Loss-making companies | Can't use P/E |
| High-growth companies | Profits haven't emerged |
| Same industry comparison | Margins may normalize |
Selecting Comparable Companies
Good comparables share:
- Same industry
- Similar size
- Similar growth rate
- Similar geography
- Similar business model
| Strong Comparable | Weak Comparable |
|---|---|
| Similar margins | Very different margins |
Garbage comparables lead to garbage valuations. Spend time finding truly similar companies.
Premium and Discount
When is premium justified?
| Factor | Premium For |
|---|---|
| Lower risk | More stable |
When is discount justified?
| Factor | Discount For |
|---|---|
| Concentration risk | Customer/product |
| Liquidity issues | Minor players |
Applying the Method
Example: Valuing Company X
| Peer | P/E | Growth | Margin |
|---|---|---|---|
| Company A | 25 | 15% | 20% |
| Company B | 22 | 12% | 18% |
| Company C | 28 | 18% | 22% |
| Average | **25** | **15%** | **20%** |
Company X:
- EPS: ₹50
- Growth: 18% (above average)
- Margin: 22% (above average)
Fair P/E: 25 × 1.1 (10% premium for better metrics) = 27.5
Fair Value = ₹50 × 27.5 = ₹1,375
Historical Comparison
Compare to own history:
| Timeframe | Average P/E |
|---|---|
| 5-year | 22 |
| 10-year | 20 |
| Current | 30 |
Is current premium justified by improved fundamentals?
Sector Averages
Industry benchmarks:
| Sector | Typical P/E Range |
|---|---|
| IT Services | 20-30 |
| FMCG | 40-60 |
| Banking | 10-20 |
| Pharma | 25-40 |
| Auto | 15-25 |
Sector averages can be elevated during bull markets. Compare to long-term averages, not just current peers.
Limitations
| Issue | Reality |
|---|---|
| Backward looking | Uses historical data |
Combining with DCF
Best practice:
- Do relative valuation (quick check)
- Do DCF (absolute check)
- Compare results
- Investigate differences
Key Takeaways
- Relative valuation compares to similar companies
- P/E, P/B, EV/EBITDA are common multiples
- Choose truly comparable companies
- Justify premiums or discounts
- Use alongside absolute valuation (DCF)
Next: How do you figure out what's the right margin of safety?
Sources & Disclaimer
- CFA Institute - Equity Asset Valuation
- NCFM Fundamental Analysis Module
Note: Any benchmarks (e.g., "Good ROE is > 20%", or specific P/E ranges) are simplified industry heuristics for educational purposes. True evaluation depends on specific industry context, market cycles, and individual company circumstances.