What is the model of relative estimation’
The relative valuation model is a method of business valuation, which compares the value of the company with its competitors or industry peers to assess the financial viability of the firm. Relative valuation models are an alternative to absolute value models, which try to determine the intrinsic value of the company based on its expected future free cash flows discounted to their present value, without any reference to another company or industry average. As the absolute value model, investors may use relative valuation models when determining the company’s stock is a good buy.
Comparative assessment uses multipliers, averages, indicators and benchmarks to determine the value of the company. The benchmark can be chosen by finding the industry average and the average is used to determine relative values.
Breaking down the relative valuation model’
Relative Valuation Multiples
There are many different types of relative performance evaluation such as cash flow, enterprise value (EV), Operating margin, cost of cash flow from property and the sales price (P/S) for the retail trade.
One of the most popular relative valuation multiples price-earnings ratio (P/E). It is calculated by dividing the share price on earnings per share (EPS), expressed as a company’s stock price as a multiple of its earnings. A company with a high ratio of P/E is trading at a higher price for a dollar of earnings than its peers and is overpriced. In addition, companies with low P/E is trading at a lower price per dollar of EPS and is considered to be undervalued. These frames can be made with any multiple of price to estimate the relative market value. Thus, if the average P/E of 10x for the industry and specific enterprises in this sector is still trading at 5x earnings, it is undervalued relative to its peers.
An absolute measure on the other hand, makes no external references to a standard or average. Company by market capitalization, which is the total market value of all outstanding shares of the company, expressed as a dollar amount and tells a bit about its relative value. Of course, with enough absolute performance evaluation in several firms, the relative conclusions can be drawn.
How to determine the relative value of the stock
In addition to providing a gauge of relative value, the P/E ratio allows analysts back to the price that the shares should be trading on the basis of their peers. For example, if the average P/E for specialty retailers is 20x, it means that the average price of the shares of the company in the industry trades at 20 times its EPS.
Suppose the company sells for $ 50 on the market and the earnings per share of $2. The coefficient P/E is calculated by dividing the $50 by $2, which is 25x. This is higher than the industry average of 20x, which means the company is overvalued. If the company traded at 20 times its EPS, the industry average, it will trade at a price of $40, which is a relative value. In other words, on the basis of the industry average, the company trades at a price that is $10 higher than it should be, representing the ability to sell.
Because of the importance of developing an accurate benchmark or the industry average, it is important to only compare companies in the same industry and market capitalization at calculation of relative values.