Introduction
Many analysts find it difficult to do the relative valuation of the company. But, we have made it simple for you. This article will act as a guide on how to do the relative valuation of companies. Also, we have given 4 easy steps with an example of relative valuation in excel. Apart from that, we have also given the pros and cons of relative valuation. Let’s check it out.
What Is Relative Valuation?
Relative valuation is a method of business valuation. In relative valuation, you try to compare one company’s data with another. Basically, you use certain ratios and then compare your company with others.
For eg, assume you want to buy a house at a good price. For that, you basically need to compare the prices of different houses based on different factors like locality, area, facilities, etc. Eventually, you will decide which house to buy. Similar is the case with relative valuation.
Although there are some pros and cons of relative valuation, it is quite a simple way to value a company. Likewise, investors might use the relative valuation model approach to decide which stock to buy.
Types Of Relative Valuation Models
Relative valuation tells us the company’s value in comparison to its competitors or the industry. Now that you know about relative valuation, let’s understand the different types of relative valuation models. The following are the types of relative valuation models. Let’s check it out.
Comparable Company Analysis (Comps)
Comparable Company Analysis or Comps basically uses different ratios and then compares different companies. For eg, assume your company operates in the textile sector. Now, if companies in the textile sector have 10x earnings, even your company should have 10x earnings. The rule is as simple as that.Now, certain companies will want to do Comparable Company Analysis. For doing this type of analysis, you need to do detailed research about the company. It includes the company’s location, in which industry does it operates. Besides that, you also need to find the number of employees working in the company and calculate different ratios. Lastly, you need to calculate the Mean and average of the ratios of the companies. Below is an example of relative valuation, you can check it out.
Precedent Transaction Analysis
Precedent Transaction Analysis is a type of valuation method where you basically try to use the past “M&A” data to predict the company’s value today. It is a very common method used for mergers and acquisitions. You can actually know the value of the business today if you had to sell it. At the same time, it uses different ratios to calculate the company’s value in today’s time. This method is basically used by analysts and investors when they feel the company is going to acquire another company. You can also use this method to find the current market trends of the industry.
However, this method includes takeover premium which is not a part of Comps. Takeover premium is the extra amount of premium paid by the acquiring company. If you wish to calculate through Precedent Transaction Analysis, you need to note down certain things. Firstly, you should have the data related to the merger and acquisitions. But sometimes, it is difficult to find the data related to M&A. Besides that, you should also research about the company nicely. Secondly, choose the multiples you will be using for the calculation. These include EV/EBITDA, EV/EBIT, and EV/Sales.
Relative Valuation Ratios
Relative Valuation uses different ratios and multiples to calculate the mean and average of the companies. These include the Price to Sales ratio, Price to Book ratio, EV/EBITDA multiples, etc. The following are the different ratios used for calculating relative valuation. Let’s check it out.
1. Price to Sales Ratio: This ratio basically tries to compare the price of the stock to the sales of the company. Therefore, if you have a low P/S ratio, it means that your stock is undervalued.
2. Price to Book Ratio: P/B ratio basically compares the stock price to the book value of the net assets of the company. In other words, it tells how much the investors are paying for the assets of the company.
3. EV/EBITDA Multiple: Another multiple mostly used in the industry is EV/EBITDA. This is very much similar to Price to Earnings ratio. Here, you actually try to divide the Enterprise value by the EBITDA. The value you get tells the n.o of times the company is earning more.
4. EV/EBIT: EV/EBIT basically compares the Enterprise value to EBIT. The answer you get is in “X Times”. If the value of EV/EBIT is higher, it tells that the stock is overvalued.
How To Do Relative Valuation Of A Company?
Now that you know briefly about relative valuation, let’s look at how to calculate the relative valuation of a company. As there are two methods, we will discuss how to do relative valuation using Comps Analysis. There are 4 easy steps to calculate the Relative valuation of various companies. Below is an example of relative valuation in excel, do have a look. Now let’s understand the steps for doing relative valuation.
- Step 1 (Select the company): The first and the foremost step includes collecting data of the company for whom you want to do relative valuation. You can choose any company of your choice. But, make sure that the company has all the data available.
- Step 2 (Find companies in the same sector): The next step is to find similar companies or companies in the same sector. This is done because if you select similar companies, you can compare the data and analyze the data effectively. Next, list down the prices, market cap, sales, and revenues of all the companies.
- Step 3 (Calculate the ratios and Multiples): Now, that you have selected the companies, calculate the ratios of the companies. These ratios include EV/EBITDA, P/B ratio, P/S, etc.
- Step 4 (Calculate the median and average): Lastly, calculate the Average and Median of the multiples you have calculated. For eg, if the average EV/EBITDA is 12.5x, the analyst needs to multiple the earnings by 12.5 times to arrive at their equity value.
Example Of Relative Valuation
Now that you know how to calculate relative valuation, let’s understand with the help of an example. Here, is an example of some pharma companies in the US. These companies include CVS Health, UnitedHealth Group, Mckesson, and Cardinal Health. Meanwhile, we have calculated Relative valuation in Google sheets. We have taken data from various sources like MSN, Investing guru, etc. Let’s check it out.
1. Find Price, Market Cap, EV
The first step of calculating relative valuation is to “Collect the data of the companies“. In this example of Relative Valuation, we have taken companies from the pharma sector. Before that, make sure you have selected companies in the same industry. For finding the data, you can visit Google Finance, Investing Guru, MSN. In short, here you will get all the data regarding the price of the share, and the market cap of the company.
In the meantime, for financial data, you can visit Investing guru. They have properly arranged all the data. As you can see, the Sales or Revenue of CVS health in the last year is $292,111 million. Meanwhile, you can calculate the Enterprise value of the companies.
Likewise, you can calculate EBITDA for the companies. For instance, the EBITDA of CVS Health is $12,923 million. Similarly, we have also calculated for the remaining companies.
2. Calculate the EV/EBITDA, EV/Sales...
The next step is to “Calculate the multiples” of the companies. Basically, there are many ratios and multiples you can calculate. Some of them are EV/EBITDA, EV/EBIT, EV/Sales, Price to Sales (PS) ratio, P/E ratios, etc. Here, we have calculated EV/EBITDA, EV/EBIT, and EV/Sales. The answer you will get is in times. But, before that, calculate EBIT. For calculating EBIT, you need to deduct D&A from EBITDA.
Thus, if you want to calculate EV/EBITDA, you need to divide Enterprise value(EV) by EBITDA. For example, the EV/EBITDA of CVS Health is 23.03 times. Similarly, we have calculated for other companies also.
Likewise, the value of EV/Sales of Mckesson company is 0.17 times whereas of UnitedHealth company is 2.72 times. Thus, calculate the values for other companies also.
3. Find The Mean And Median Of The Multiples
Now, that you have calculated the multiples of the companies, it’s time to “Find the Mean and Median of the multiples“. For calculating mean, you need to just type [=Average(number of cells)]. Bit confusing, isn’t it? Let’s make it more simple. Here, are the following steps to calculate Mean and Median in excel.
1. Type the function [=Average(number of cells)]. Here, in place of the number of cells, just drag the cells for which you want to calculate the Mean. Basically, in the example of relative valuation, we have dragged the EV/EBITDA cells.
2. Now, after you have typed the function, just click enter. You’ll get the value of Mean.
Similarly, calculate the value of the Median. The Excel function of Median is [=Median(number of cells)]. Here, also in place of the number of cells, just drag the cells you wish to calculate Median for.
The Mean of EV/EBITDA is 13.377 whereas that of EV/EBIT is 13.43. Likewise, the Median of EV/Sales is 0.598 whereas that of EV/EBITDA is 12.63.
4. Calculate The Company's Value
The last step is to “Calculate the company’s/equity value from the Mean and Median“. Now, you can easily find the value of the company using the mean and median. Here is how you can find the value of the company.
1. Now, that you have calculated the mean and median, use any of the multiple to find the Enterprise value. From the above example, we will calculate the Enterprise value of CVS health.
EV/EBITDA = 13.37 (Industry Mean)
EV/12,923 = 13.37
EV = 13.37 x 12,923
EV = $172,780.51
2. Next, calculate the Equity value of the stock. You just need to apply the formula for equity value. We will calculate the equity value of CVS Health. The formula for Equity is;
Equity Value = Enterprise Value – Preferred Shares – Minority Interest – Outstanding Debt + Cash & Bank
= 172,780.51 – 0 – 0 – 83,855 + 94,080
= $183,005.51
Likewise, you can also calculate the value of the stock. You just need to divide the equity value by the number of outstanding shares. So, the value of stock comes out to be $138.54. Similarly, you can also calculate for other companies.
Relative Valuation Vs DCF Vs Absolute Valuation
Now that you know how to calculate relative valuation, let’s understand the difference between Relative valuation, discounted cash flow, and Absolute valuation. Let’s check it out.
Relative Valuation | Discounted cash flow | Absolute Valuation |
Here, you basically try to find the company’s value by comparing it with other companies. | Meanwhile, Discounted cash flow helps to find the company’s value through future cash flows. | Absolute Valuation basically tries to find the company’s value through the DCF model. |
It is easy and simple | This method is a little difficult to calculate. | An absolute valuation can only be calculated if you know the DCFand DD model. |
Basically, there are two methods; Comparable company analysis and Precedent Transaction Analysis. | There is only one way to calculate the DCF model. | Here, there are two methods; Discounted cash flow model and the Dividend Discount Model. |
Pros And Cons Of Relative Valuation
Just like every method, even there are some pros and cons of relative valuation. These pros and cons of relative valuation will help you whether to select absolute valuation or relative valuation. The primary benefit is that it is very easy and simple to calculate. Also, you do not need to do the tough calculations in relative valuation. Besides that, it needs less financial data. Thus, companies having limited information can use this method. Another advantage is that using Comps analysis can be less time-consuming and also more efficient.
On the other hand, apart from the pros, there are some cons of relative valuation also. Firstly, there are some assumptions of this method, which sometimes make it less accurate. Also, the value obtained can’t be said perfectly accurate.
Conclusion
Relative valuation of a company is a technique used to gauge how expensive or cheap a company is compared to its peers in the industry or other companies in the market. This technique, which is also called comparative analysis, can help you make better-informed investment decisions. In this article, we have provided a detailed guide on how to do a relative valuation of a company. You will also find that we have given a step-by-step guide with the help of an example of relative valuation. Also, we have stated the pros and cons of relative valuation. We hope this article helped you with your queries. Thank you for reading, we are always excited when one of our posts is able to provide useful information on a topic like this!