02/11/2024, 12:33 What is Relative Value?

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What is Relative Value?

1 year ago · Updated

Relative valuation is a method used to determine a stock's value by examining how

the market prices similar companies. To understand this, think of buying a house:
you'd typically look at what similar homes in the neighborhood have sold for, rather
than determining the value of the house based on its individual components. Likewise,
in stock investing, people often gauge whether a stock is cheap or expensive by
comparing its price to that of similar stocks.

Valuation Using Multiples

The term "multiples" refers to various indicators that can be used to value a stock. A
multiple is a ratio, calculated by dividing the market value of an asset by a specific
financial metric. These standardized financial metrics allow for value comparisons
among companies of different sizes. For example, if we want to compare the prices of
two differently sized buildings in the same location, we'd look at the price per square
foot to make a fair comparison.

Standard Multiples
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Prices can be standardized using variables like earnings, cash flows, book value, or
revenues. We provide information on several ratios:

P/S. The Price to Sales ratio is a valuation multiple that compares a company’s
market capitalization to its revenues. It is an indicator of the value that financial
markets have placed on each dollar of a company’s sales.
P/E. The Price to Earnings ratio is a valuation multiple that compares a
company’s market capitalization to its net income. It indicates the dollar amount
an investor can expect to invest in a company in order to receive $1 of that
company’s earnings.
P/OCF. The Price to Operating Cash Flow ratio is a valuation multiple that
measures the value of a company’s market capitalization relative to the
operating cash flow it generates. Some analysts prefer P/OCF over P/E since
earnings can be more easily manipulated than cash flows.
P/FCFE. The Price to Free Cash Flow to Equity ratio is a valuation multiple that
compares a company’s market capitalization to the amount of free cash flow
available for equity shareholders. This metric is very similar to the P/OCF but is
considered a more exact measure, owing to the fact that it uses free cash flow,
which subtracts capital expenditures (CapEx) from a company’s operating cash
flow.
P/B. The Price to Book Value ratio is a valuation multiple that measures the
market’s valuation of a company relative to its book value. The P/B ratio is only
considered useful in practice when applied to capital-intensive businesses.
EV/S. The Enterprise Value to Sales ratio is a valuation multiple that compares
the enterprise value (EV) of a company to its revenues. The EV/S multiple gives
investors a quantifiable metric of how to value a company based on its sales
while taking into account both the company’s equity and debt.
EV/EBITDA. The Enterprise Value to EBITDA ratio is a valuation multiple that
compares the value of a company, debt included, to the company’s cash
earnings less non-cash expenses. EBITDA can be misleading at times, especially
for companies that are highly capital-intensive.
EV/EBIT. The Enterprise Value to EBIT ratio is a valuation multiple that compares
the value of a company, debt included, to the company’s earnings before interest
and taxes (EBIT). Considered one of the most frequently used multiples for

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comparisons among companies, the EV/EBIT multiple relies on operating income

as the core driver of valuation.
EV/OCF. The Enterprise Value to Operating Cash Flow ratio is a valuation
multiple that measures the value of a company, debt included, to the operating
cash flow it generates.
EV/FCFF. The Enterprise Value to Free Cash Flow to Firm ratio is a valuation
multiple that compares the value of a company, debt included, to the amount of
free cash flow available for all stakeholders. This metric is very similar to the
EV/OCF but is considered a more exact measure, owing to the fact that it uses
free cash flow, which subtracts capital expenditures (CapEx) from a company’s
operating cash flow.
EV/IC. The Enterprise Value to Invested Capital ratio is a valuation multiple that
measures the dollars in Enterprise Value for each dollar of capital invested by
shareholders and lenders.

Forward-Looking Multiples

A forward multiple is a version of a multiple that uses a forecasted variable for its
calculation. For example, a forward P/E is a version of the P/E ratio that uses
forecasted earnings for its calculation.

Multiples Benchmarks

To assess if a multiple is high or low, it must be compared to a benchmark. We

provide historical values of the multiple, as well as its industry average, for this
purpose.

Calculating Relative Value

Alpha Spread consolidates all the information about a company's valuation multiples
into a single number called Relative Value. Our algorithm estimates a target multiple
for each valuation metric and calculates the stock value accordingly. The average of
these values is the relative value.
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The quality of this valuation relies on the calculation of the target multiple. Our
algorithm accounts for:

Multiple’s historical values. It analyzes the historical distribution of multiple

values to understand how a company has historically been valued.
Growth prospects. A company with high expected growth should trade at a
higher multiple than a company with lower expected growth. Our algorithm uses
regression models to calculate the relationship between the multiple value and
the expected growth.
Industry multiple value. Our algorithm analyzes the multiple values of
companies located in the same industry to increase the accuracy of the target
multiple estimate.

The Bottom Line

Relative valuation is used to value companies by comparing them to other businesses

based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E ratios. Alpha
Spread takes into account all the information about the company’s valuation multiples
and consolidates it into one single number – Relative Value.

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