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Relative valuation examines a company by comparing its financial metrics and valuation multiples with those of similar companies or the broader market.
Instead of estimating a company’s intrinsic value independently, investors assess whether its shares appear relatively expensive or inexpensive compared with comparable businesses.
This article breaks down relative valuation, how it is calculated, and FAQs.
Key Takeaways
- Compare companies with similar size, growth, business models, and industry characteristics.
- Relative valuation reflects current market sentiment but can also reflect sector-wide mispricing.
- Use multiple valuation ratios, such as P/E and EV/EBITDA, rather than relying on one metric.
- A stock may look cheap or expensive relative to peers, without indicating whether the entire sector is fairly valued.
- Use relative valuation as a screening tool, not the sole basis for an investment decision.
What Does Relative Valuation Mean?
It's a way to figure out a company's worth by comparing its financial metrics with similar companies, usually within the same industry.
The logic is simple: similar businesses should trade at roughly similar valuations, so if one looks noticeably cheaper or pricier than its peers, it's worth digging into.
Most of this work leans on ratios like Price-to-Earnings (P/E), Price-to-Book (P/B), Price-to-Sales (P/S), Price-to-Cash-Flow (P/CF), and Enterprise Value to Earnings Before Interest, Tax, Depreciation, and Amortisation (EV/EBITDA). The appeal here is speed, really.
Unlike a full discounted cash flow model, this can be pulled together quickly using already public data, which is a big reason it's such a common first step for analysts and everyday investors alike.
What Metrics Get Used in Relative Valuation?
- Price-to-Earnings (P/E) Ratio: Compares share price to earnings per share; probably the most commonly cited valuation metric.
- Price-to-Book (P/B) Ratio: Compares market value to book value, often used for asset-heavy businesses like banks.
- Price-to-Sales (P/S) Ratio: Handy for companies that aren't profitable yet, since it doesn't rely on earnings at all.
- Enterprise Value to Earnings Before Interest, Tax, Depreciation, and Amortisation (EV/EBITDA): Compares enterprise value to core operating earnings, useful because it accounts for debt.
- Price/Earnings-to-Growth (PEG) Ratio: Adjusts the P/E ratio for expected growth, helping distinguish genuinely undervalued stocks from ones that look cheap because growth's slowing.
How do You Calculate a Relative Valuation?
To understand how relative valuation translates into numbers, imagine you are evaluating a business by looking at how the wider market prices its closest competitors.
By establishing an average market multiple and applying it to your target company's earnings or core profit metrics, you can estimate what its shares should trade at if it matched peer pricing.
Here is a full worked example showing how this comes together, valuing a hypothetical two-wheeler manufacturer called ABC Limited using its peers.
Step 1: Identify Comparable Companies
Three peers are picked out: DEF Limited, LMN Limited, and XYZ Limited, all roughly similar in size and growth profile.
Step 2: Gather Their Key Ratios
|
Company |
P/E Ratio |
EV/EBITDA Ratio |
|
DEF Limited |
25 |
15 |
|
LMN Limited |
22 |
13 |
|
XYZ Limited |
28 |
17 |
|
Average |
25 |
15 |
Formula
Average Ratio = Sum of Peer Ratios ÷ Number of Peers
-
Sum of peer ratios: The total of the P/E or EV/EBITDA figures across the comparable companies.
-
Number of peers: The count of companies in the comparison group.
Example for the Average P/E
Average P/E = (25 + 22 + 28) ÷ 3 = 25
Step 3: Apply the Average Ratio to ABC Limited's own Numbers
Say ABC Limited earns ₹10 crore in net income a year and has an EBITDA of ₹15 crore.
-
Valuation based on P/E: ₹10 crore 25 = ₹250 crore
-
Valuation based on EV/EBITDA: ₹15 crore 15 = ₹225 crore
Both methods land in a similar range, which adds a bit more confidence to the estimate.
If ABC Limited's actual P/E is 20, below the peer average of 25, that signals the stock may be undervalued relative to its peers and worth a closer look.
Types of Relative Valuation
-
Comparable Company Analysis: Most widely used version, comparing a company against close peers using current market data. It reflects live sentiment well, but assumes the market's pricing those peers correctly to begin with, which isn't always true.
-
Precedent Transaction Analysis: Looks at recent mergers and acquisitions involving similarly sized companies to estimate value. Useful for deal pricing specifically, though transaction data can be hard to get hold of and goes stale fast.
How is Relative Valuation Different from Intrinsic Value?
|
Factor |
Relative Valuation |
Intrinsic Value |
|
Core Approach |
Compares a company against similar peers |
Estimates worth from expected future cash flows |
|
Speed |
Fast, can be done with public ratios |
Slow, needs detailed forecasting |
|
Data Needed |
Peer company ratios |
Cash flow projections, discount rate, growth assumptions |
|
Best Suited For |
Quick screening and preliminary analysis |
Deep, standalone fundamental analysis |
|
Main Weakness |
Assumes peers are priced correctly |
Highly sensitive to the assumptions used |
Where Does Relative Valuation go Wrong?
-
The whole peer group can be mispriced: An entire sector trading at inflated valuations means a stock that looks cheap relative to peers might still be expensive in absolute terms.
-
It leans heavily on historical data: Past ratios don't necessarily predict future performance, especially for companies undergoing genuine change.
-
Company-specific factors get ignored: Two companies in the same industry can carry very different risk profiles, debt levels, or growth trajectories that a simple ratio comparison just misses.
-
Metrics can be manipulated: Earnings and other reported figures don't always cleanly reflect what's actually happening underneath.
Conclusion
Relative valuation earns its popularity honestly: it's fast and intuitive, and comparing a company against its peers gives you a quick read on whether it looks cheap or expensive without building a full model from scratch. It assumes the peer group is priced fairly, and it says little about a company's future prospects on its own. Using two or three metrics together instead of just one, and treating this as a starting point rather than a final answer, tends to separate investors who use it well from those who get misled by it.
