Relative valuation: How to compare a stock's worth with its peers?

Investing with moomoo joined discussion · Jul 8, 2021 10:47

Relative valuation: How to compare a stock's worth with its peers?

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Stock valuation methods

Absolute valuation: Analysts’ secret weapon

To value a company, we can apply many different techniques, such as the absolute valuation method we've talked about before.

Relative value is the opposite of absolute value. Absolute value looks for the intrinsic value of an asset or company, relative value is based on the value of other similar companies.

Types of relative valuation models

There are many different kinds of relative valuation ratios, such as EV/Revenue, EV/EBITDA, price to cash flow for real estate, price-to-sales (P/S) for retail, and P/E ratios.

For example, the logic of applying P/E in relative valuation is if comparable companies are worth 5x earnings, then the company that’s being valued should also be worth 5x its earnings.

1. P/E ratio

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is calculated by dividing the stock price by earnings per share (EPS).

（1）A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued.

（2）A company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued.

Learn more: How to value a stock with the P/E ratio？

2. P/S ratio

P/S ratio can be applied in valuing growth stocks that have yet to turn a profit or have suffered a temporary setback.

The price-to-sales ratio (or P/S) is calculated by taking a company's market capitalization and dividing it by the company's total revenue over the past 12 months.

The lower the P/S ratio, the more attractive the company investment.

Learn more: How to value a stock: Price-to-sales ratio (P/S) explained

3. Enterprise multiples

Enterprise value (EV) is a measure of the economic value of a company. It is mostly used to calculate the value of the company if it is acquired.

In relative valuation, some of the most used EV ratios are Enterprise-Value-to-Revenue (EV/R) multiple and Enterprise-Value-to-EBITDA (EV/EBITDA) multiple.

The enterprise value-to-revenue (EV/R) looks at a company's revenue-generating ability, while the enterprise value-to-EBITDA (EV/EBITDA) looks at a company’s ability to generate operating cash flows.

The advantage that EV/R has is that it can be used for companies that are yet to generate income or profits, such as the case with $Alphabet-A (GOOGL.US)$ in its early growth stage.

Limitations

Like any valuation tool, relative valuation has its limitations.

1. The biggest limitation is the assumption that the market has valued the business correctly. During market bubbles or before market crashes, most investment targets, especially in the tech industry, are overvalued. Investing in a firm because its P/E was 50 versus an industry average of 70 would be a painful mistake.

2. All valuation ratios are backward-looking based on past data, so relative valuation does not take the future growth into account.

3. Relative valuation cannot guarantee that the "cheaper" company will outperform its peers.

Though relative valuation has limitations, it is a very important tool used by many analysts and professional investors.

How to apply relative valuation ratios in moomoo?
1. View valuation ratios