This is the last part of the basic course in my series on valuation. In Valuation 102 and 103, we talked about all things intrinsic valuation. Now, in this last piece of the basic course, lets delve into the world of relative valuation.
What we essentially do in a relative valuation is we decide the value of an asset based on how similar assets are valued in the in the markets, rather than based on inherent characteristics of individual companies.
So, your first question is probably why am I dedicating two parts of the series to intrinsic valuation and only one to relative valuation? The answer is simple. You can do all the relative valuation you want, but nothing trumps intrinsic valuation. This is because relative valuation is based on valuation multiples which may or may not be well defined and assumptions or thumb rules which may or may not be true. Whereas the data we use for intrinsic valuation, namely cash flows, growth rates and discount rates, are much more accurately defined and believable. Ergo it is always better to focus more on intrinsic valuation.
That begs the question, why use relative valuation? Consider this. There are around 5000 listed companies in India. Can we individually do an intrinsic valuation of all 5000 companies? Definitely not. That’s where relative valuation comes in. Using the thumb rules of relative valuation and valuation multiples, it is possible to screen for seemingly cheap companies and further our valuation research with an intrinsic valuation of those companies. In other words, if valuation is a three course meal, think of relative valuation as the starter, intrinsic valuation as the main course, and the satisfaction of getting your ultimate valuation right as the dessert.
But as a reward for reading this piece, I’m going to throw in the bonus of sharing a four step process with you, which will help you use relative valuation better. So when using a valuation multiple, remember to always:
- Define: Every valuation multiple must first be well defined. There are two rules that a valuation multiple must satisfy to be classified as well defined. First, the numerator must show what you are paying for the asset, and the denominator must show what the asset is earning for you. Second, if the numerator is an equity or firm value, the denominator must also be an equity or firm value.
Take the PE ratio for example. PE ratio = Market Price/ EPS. So in the numerator you have the market price which is what you pay for the stock, and in the denominator you have the earnings per share, which is one of the things that the stock annually earns for you. First rule satisfied. Now, market price and EPS are both equity values. Second rule satisfied. Praise be to the Gods, the world’s most widely used equity valuation multiple is well defined.
Lets look at the most widely used firm valuation multiple. The EV to EBITDA ratio. EV to EBITDA ratio = Enterprise Value/EBITDA. In the numerator, you have the Enterprise Value, which is the value of the firm as a whole, and when you buy the stock of a firm, you indirectly pay a part of the Enterprise Value. In the denominator, you have the EBITDA, which is nothing but the operating income of the firm, which is what the firm as a whole earns during a given period. First rule satisfied. Now, EV and EBITDA are both firm values, hence the second rule is also satisfied. I think we can all sleep peacefully tonight, safe in the knowledge that both the world’s most widely used equity valuation multiple and firm valuation multiple are well defined.
Remember, if the multiple is not well defined, there is no use in going on to further steps in the process and should be dropped straight away.
Describe: Once the valuation multiple has been proven to be well defined, put various values of the multiple into a frequency distribution and create a histogram from the data. Fair disclosure, I was never a math or stats whiz, so I usually make mistakes in this part of the process. Thank God for Excel. Once you do this you should be able to get a fair idea of what is high, what is low, and what is fair, as far as values of the multiple are concerned. When trying to find a benchmark for comparison, compare each value with the median value of the distribution. We would normally use the mean of the distribution, but the problem with doing that here is that the mean tends to be highly skewed and therefore the comparisons may lead to distorted results.
Analyse: Every valuation multiple is made up of a combination of variables. But in every multiple, there is one variable around which the multiple is centered, which is known as the companion variable or the driver variable. Isolate the driver variable and see what effect, changes in the driver variable have on the valuation multiple. I have given a list of driver variables for commonly used valuation multiples below:
PE ratio - Earnings Growth
Price To Book ratio - Return On Equity
Price To Sales ratio - Net Profit Margins
EV To EBITDA ratio - Earnings Retention Ratio
EV To Capital ratio - Return On Capital
EV To Sales ratio - After Tax Operating Margins
Most of the time, the driver variable is directly related to the value of the multiple. That is to say, higher the driver variable, higher the multiple and vice versa. But every so often you come across a company where the driver variable is high but the corresponding multiple is low. This is the first sign of an undervalued company.
- Apply: Once the valuation multiple has passed through the tests of the first three steps, it is highly likely that it can be used as a measure of relative valuation. So go ahead and actually test it out.
So in summary, relative valuation cannot substitute for an intrinsic valuation, but it can serve as a screen to help identify seemingly cheap companies, and these companies can further be probed using intrinsic valuation. Follow the four step process described above and you should be okay when using valuation multiples. Also, just because you find a stock with a high driver variable value and a low multiple value, don’t dive in and buy the stock just because it is cheap on a relative basis. Run an intrinsic check and see whether there is actually some substance behind the show. Remember, we are looking for companies that are cheap but don’t deserve to be cheap, not for ones which are deservedly cheap.
I have tried to cover as much as possible on relative valuation in this piece, but if you have further queries, leave a reply and I’ll be happy to respond to your queries.
That concludes the basic course in my series on valuation. Starting next week, we begin the intermediate course, where we will discuss valuation of companies based on their relative stage in the company life cycle.