Relative Valuation

Relative valuation compares a stock's valuation multiples against those of similar companies in the same sector. Instead of calculating intrinsic value from scratch, it asks: is this stock cheap or expensive compared to its peers?

Common multiples used in relative valuation include Price-to-Earnings (P/E), Enterprise Value to EBITDA (EV/EBITDA), Price-to-Sales (P/S), and Price-to-Book (P/B). Each multiple has strengths and weaknesses depending on the industry and company characteristics.

Relative Valuation in Practice

To perform relative valuation, identify a peer group of comparable companies, calculate the average or median multiple for the group, and compare the subject company's multiple. A company trading below the peer average may be undervalued; one trading above may be overvalued.

Fair Price Index uses relative valuation as 30% of its blended model, comparing each stock's multiples against sector averages. This provides a market-based reality check on the DCF analysis.

The limitation of relative valuation is that it assumes peers are fairly valued. If an entire sector is overvalued, a stock that looks cheap relative to peers may still be expensive in absolute terms.