Introduction
As the name suggests, this model of valuation compares the value of a company to that of its competitors or industry peers to assess the financial worth of the company. It is considered as one of the simplest and easiest to use valuation models and is the most popular choice among investors and analysts for swift assessments.
This model used certain metrics such as EV/EBITDA, PE ratio, PEG ratio, Price-to-book value (P/B) ratio, and EV/Revenue to make the comparisons.This model used certain metrics such as EV/EBITDA, PE ratio, PEG ratio, Price-to-book value (P/B) ratio, and EV/Revenue to make the comparisons.
Types of Relative Valuation
Once you understand the meaning and the difference between relative and absolute valuation, let’s look at the different types of relative valuation.
• Comparable Company Analysis
Comparable companies widely use types of relative valuation, which involve comparing a company with highly similar players in the market. These companies are publicly traded companies with similar businesses and operate within the same market.
Public companies are required to publish financial performance in detail which helps to compare their performances and values. As this approach uses real time data, it often helps the investors to make more efficient decisions. In addition to this, this method is quite simple and easy to perform.
However, this method is not free from limitations, as it assumes that the market always prices the comparable companies efficiently, and does not take into account the strengths, risk, or the future growth potential of the companies.
• Precedent Transaction Analysis
Another type of relative valuation is the precedent transaction analysis which is commonly used by investors and large financial institutions. This approach looks at the previous mergers and acquisitions transactions of similar sized companies to determine the company’s value.
These transactions helps to understand the value of the company as it analyses what the investor was willing to pay for the entire business. It also uses ratios such as EV/EBITDA etc. However, this method is also not free from limitations – the transaction of data of mergers and acquisitions are not easy to collect, the collected can become out of date and might not reflect the accurate results.
Advantages of Relative Valuation
Every valuation method has its own set of pros and cons and to understand the method better, it’s important to look for both. Let’s look for the key advantages of Relative valuation method,
- This method can easily measure a company’s performance in relation to its competitiors in the wider market.
- This method can easily measure a company’s performance in relation to its competitiors in the wider market.
- This method is less time-consuming and more convenient.
- This method uses various valuation ratios making it more effective and efficient to use.
- It can value a company without accessing proprietary data.
Limitations of Relative Valuation
Now that we have understood the advantages of the method, it’s time to look for the limitations,
- Historical data is might not always indicate the best analysis of the future performance of the company.
- This method uses a lot of assumptions that might not be true in many cases.
- This method assumes that the market has valued the business correctly, which can be wrong at many times.
- Relative valuation does not take into consideration the challenging changes such as robotics, artificial intelligence, making it difficult to predict the future.
- This method uses external observations which can be misleading at many times.
- There’s a possibility of certain ratios being manipulated to appear a better performing company.
- Some industries can be overvalued which can result in non-effective analysis of the companies.
Relative Valuation Vs Absolute Valuation
While relative valuation method uses ratios, average, and benchmarks to determine a company’s value, the absolute valuation method doesn’t use any external reference to a benchmark or average.
A benchmark can be selected by determining industry wise average which can be further used to determine the relative value.
Relative Valuation Vs Intrinsic Valuation
Relative valuation method analyse the value using its historical data by making comparsion of a company’s with that of its peers. Whereas Intrinsic Valuation method determine a company’s valuation based on its expected future cash flows, risk factors, and growth potential.
However when relative valuation method seems easy and simple to perform and understand, intrinsic valuation approach is much more complex and time taking.
Intrinsic valuation approach includes detailed analysis and data of the company’s buisness, whereas relative valuation does not go for in-depth analysis and uses publicly available data.
Conclusion
To conclude relative valuation model is a useful tool which helps to determine the value of a company in a quick manner. Whether you are using a Comparable company or a Precedent transaction analysis method, both have its advantages and disadvantages.
This approach helps many investors to effectively analyse the potential investment opportunities without taking a lot of their time and money. However, this method is only viable for preliminary analysis and does not work well for an in-depth analysis of the company. You can absolutely look for other valuation methods such as Discounted cash flow method and intrinsic value analysis for an in-depth assessment. To learn the methods of valuation in detail, you can check out our courses at the FinnovationZ.