Relative valuation (or multiple valuation) is the most intuitive and easy way to value a company.
Today we will provide a complete guide with a check list and after reading this you should be well equipped to value a company (or a house) through the use of relative valuation.
Premise of multiple valuation
The premise is to use companies similar to the company you are valuing (often this will be competitors) and use their relative valuation to value your company.
You can both use companies similar that are listed, as well as companies that have been traded in private transactions.
If you are a smaller company, the latter will usually be the most realistic and feasible, whereas if you are the CEO of Coca Cola, a natural listed peer would be Pepsi.
The steps to perform relative valuation are the following:
- Identify companies comparable to your own
- Obtain information about their relative price
- Benchmark the comparable companies
- Determine which multiples to use
- Use multiples to find the value of your business
Step 1: Identify companies comparable to your own
The first step in conducting a relative valuation is to find comparable companies to the company being valued. Companies in the same industry are usually good and easy-to-find candidates. These will also usually be the competitors of the company.
An example of a good peer is as already mentioned Coca Cola relative to Pepsi. Other good peers include Google relative to Apple and Sprint relative to AT&T.
Good peers are not limited to large, multinational corporations. If you consider buying a pizza restaurant, it would be prudent to see what multiple or earnings other pizza restaurants have been sold at.
Nor is peer valuation limited to corporate valuation. In buying a house, it is normal to see what price per square feet neighboring houses have been sold for.
In short, while there is no mathematical equation for finding comparable companies the checklist is:
- Is the company in the same industry?
- Is it the same size?
- Does it sell the same products?
If you can answer yes to all three, you have a very good peer.
Step 2: Obtain information about their relative price
Once the group of comparable companies have been identified, the next step is to find the multiples other companies are trading at.
For listed companies this is relatively easy. In the picture below, the most important financial information about Apple is prepared, courtesy of Yahoo Finance.
For stock market analysts, the most important ratio is the Forward P/E. It currently stands at 12.65x. This says that if you invest in an Apple stock right now, it will take 12.65 years at its current net income before you have been given your money back (provided everything stays as it is now).
But what if the best peers are not public market stocks? It will usually be harder to get information, however, the principles are the same. Obtain the key financial information and then calculate the ratio.
This is basically what you do, when applying relative valuation to buying a house. Information is not readily available and collected in a nice sheet from Yahoo Finance as above.
However, you can find the price of the neighboring house and you can find the size of the neighboring house and then, you can get the price per square feet.
Step 3: Benchmark the comparable companies
The third step is to benchmark the companies in the peer group to the company you are valuing. There are two aspects to this:
- Quantitative (hard) measures
- Qualitative (soft) measures
Quantitive measures are all the measures you can put a number on. These include, but are not limited to financial measures such as revenue growth, EBITDA and EBIT margin as well as balance sheet measures such as property, plant and equipment are normal benchmark items.
Further, multi-year measures such as revenue growth and margin development over time are also often benchmarked.
Finally, another quantitive measure often used to benchmark size is the number of employees, the products / services and geography.
The key rule of thumb to remember is that the more alike these figures are to the company being valued, the better a peer company it is.
Qualitative measures are the soft measures such as quality of products, management and competitive position. These are harder to measure but if you have insight into an industry it will be easier (it always is).
As an example, if you benchmark Apple to Google and only look at its mobile platform the qualitative measures we would argue the key observation is:
- Apple is perceived to be a more premium brand than Google
- Apple has higher customer loyalty
These two factors indicate that Apple should trade at a higher multiple than Google (based strictly on its mobile phones business).
Following on with our earlier example the following factors would be important in doing a benchmark analysis on a house:
- Condition of house
- Outdoor areas
Is it hard to do a benchmark analysis? No
Does it take time? Yes
Will all factors matter equally much? No
So all in all, benchmarking is relatively simple, however, it can take time when done properly.
The good news is that we are pretty much done and now we just have to apply the multiples on the company we are valuing.
Step 4: Determine which multiples to use
In determining which multiples to use there are several factors to consider. Luckily, we’re here to help and the answer is given in the figure below.
As can be seen, you should pretty much always use P/E, EV/EBITDA and EV/EBIT. This is true across industries. For the remainder, please use our diagram below as reference. On top are the Price / “variable” and below are the EV / “variable”.
Step 5: Use the multiples to find the value of your business
The trading multiples of the comparable companies serve as the basis for valuing your own company.
As an example if Google was only valued through the P/E multiple of Apple of 12.65x and we agree that the two companies are totally similar Google should be valued at 12.65x its expected earnings for the next year.
However, as we established, Apple is perceived to be of a higher quality than Google (only taking cell phones into account) and thus, Apple should trade at a premium compared to Google. With the factors we have identified it would be fair to value Google at a 10% discount compared to Apple or a P/E of
12.65*90% = 11.39x
Let’s check our valuation against the market.
Google trades at a P/E of 19.1x! Based on our analysis, Google is either grossly overvalued, Apple grossly undervalued or there were factors we did not account for. In our case, we would argue it was the latter, as Google is so much more than its Android cell phone system and Apple is much more than the iPhone.
This also highlights one of the problems with using relative valuation: No two companies are similar and Google and Apple are extreme examples in terms of the number of products both companies have. However, it highlights that it can be hard to find good peer companies.
When to use relative valuation
So when should one use multiple valuation? We would argue that you should always use multiple valuation as it shows what other people have been willing to pay for a company like yours.
As such it serves as a great sanity check and even when there are no comparable companies it could still be used.
Another way to use multiple valuation is to turn the question around and ask: “Do I think someone will pay me 7-8 times the earnings for my business?”.
If the answer is yes and you are willing to sell to that price an M&A transaction would be likely.