Relative Valuation

If DCF is about intrinsic value, relative valuation is about market context.
It doesn’t ask, “What is this worth in isolation?” It asks, “What is this worth relative to everything else?”

Every investor, consciously or not, does relative valuation. Whether it’s comparing a stock’s P/E to peers, or deciding whether bonds look cheap versus equities, the framework rests on one principle:

Value is relative, not absolute — and markets are voting machines in disguise.

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🧩 The Core Logic

At its simplest, relative valuation involves comparing a company’s pricing multiples to an appropriate peer group.
It assumes markets are roughly efficient at the group level — so deviations between peers signal opportunity.

The structure is intuitive:

Value Ratio = Market Value ÷ Fundamental Metric

Common ratios include:

• P/E (Price / Earnings) — measures what investors are paying for each unit of earnings
• EV/EBITDA — adjusts for capital structure and non-cash charges
• P/B (Price / Book Value) — useful for financials or asset-heavy sectors
• P/S (Price / Sales) — a crude measure when earnings are negative
• EV/Sales, EV/EBIT, P/FCF, and variants — all context-dependent

A company is considered “cheap” when its multiple is lower than peers, assuming fundamentals are comparable.

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🔍 The Mechanics

A proper relative valuation follows a clear workflow:

1. Define the Peer Set

Peers should share similar:

• Business models
• Risk profiles
• Growth prospects
• Capital intensity
• Geography or regulatory exposure

It’s easy to skew results by including non-comparable peers (e.g., comparing a capital-light software firm to an industrial manufacturer).
In institutional research, this is where analysts spend most of their time — defining what belongs together.

2. Normalize the Fundamentals

Raw financials aren’t enough. You need to normalize for:

• Non-recurring items (restructuring, impairments)
• Accounting differences (IFRS vs. GAAP)
• Seasonality
• One-off gains/losses

The goal is to compare core earnings power, not reported noise.

3. Calculate Multiples

Using either forward (consensus forecast) or trailing figures:

P/E = Share Price ÷ EPS
EV/EBITDA = (Market Cap + Net Debt) ÷ EBITDA

Forward multiples embed expectations. Trailing multiples reflect history.
In practice, investors use both — to see how fast sentiment and growth are being priced in.

4. Interpret the Spread

A company trading at 8x EV/EBITDA vs. peers at 12x could be:

• Undervalued, if fundamentals are comparable
• Appropriately discounted, if risk or quality is lower
• Misclassified, if accounting distorts comparability

Relative valuation is as much art as it is math.
The multiple itself is just a signal — interpretation requires judgment.

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⚖️ Multiples and What They Imply

Every multiple embeds assumptions about growth, risk, and return on capital.

For instance:

P/E ≈ (1 - g/ROE) / (r - g)

This is the Gordon growth model expressed as a multiple.
If two firms have similar risk (r) and growth (g), their P/E ratios should be similar — unless the market expects one to sustain superior ROE.

Thus, comparing multiples is really comparing expectations:

• Higher multiple → higher expected growth, quality, or durability
• Lower multiple → higher perceived risk or capital intensity

This is why context is critical. A “cheap” multiple can signal opportunity — or structural decay.

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🧠 Relative vs. Intrinsic Valuation

Feature	DCF	Relative Valuation
Focus	Absolute cash generation	Market comparables
Core Input	Forecasted FCF & discount rate	Multiples (P/E, EV/EBITDA)
Output	Intrinsic value	Implied market value
Strength	Theoretically sound	Reflects real-world sentiment
Weakness	Sensitive to assumptions	Sensitive to peer bias

DCF tells you what should be.
Relative valuation tells you what is being paid.

Used together, they create tension — and insight.
When intrinsic and relative valuations diverge sharply, it’s a signal: either your model is wrong, or the market is.

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📊 Practical Applications

1. Comparable Company Analysis (Comps)

The standard equity research toolkit:

1. Identify peers
2. Gather data (EV, EBITDA, EPS, etc.)
3. Compute median or average multiples
4. Apply to your target company’s metric
5. Cross-check with historical ranges

Example:

If peer EV/EBITDA = 10x and your company’s EBITDA = $200M,
then implied EV ≈ $2B (before adjustments).

Comps are quick, scalable, and market-calibrated — which is why sell-side analysts rely on them heavily.

2. Precedent Transactions

Used in M&A, this compares valuation multiples paid in similar deals.
These capture control premiums and synergy expectations, so they’re usually higher than trading comps.

3. Sector Rotation and Macro Context

At the portfolio level, relative valuation extends beyond companies:
Is energy cheap relative to tech?
Are small-caps trading below long-term averages?
Are equities expensive relative to bonds?

Institutional allocators use these spreads to manage risk-adjusted exposure across markets.

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⚠️ Pitfalls and Misuses

Relative valuation’s strength — simplicity — is also its weakness.

Common traps include:

• Circular reasoning: “It’s cheap because peers are expensive.”
• Ignoring quality: Low multiple ≠ undervalued. It might reflect structural decay.
• Momentum bias: Peers in bubbles reinforce each other’s overvaluation.
• Blind comparability: Applying tech multiples to industrials, or ignoring capital intensity.
• Time distortion: Using peak or trough cycle multiples to value mid-cycle earnings.

Relative valuation works best as a lens, not a crutch.

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🔄 How Pros Use It

The best investors integrate relative and intrinsic frameworks:

1. Start with DCF or business logic to anchor intrinsic value.
2. Cross-check with comps to see if the market agrees.
3. Use discrepancies to generate ideas:
   • If DCF >> market value → investigate why the discount exists.
   • If DCF << market → test whether expectations are realistic.

This interplay — between what should be and what is — defines price discovery.

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✍️ Final Thought

Relative valuation doesn’t replace DCF. It complements it.

It’s the bridge between theory and reality — where perception meets fundamentals.

A DCF tells you what a company’s worth in isolation.
Relative valuation tells you what the market is willing to pay today, given the alternatives.

Used wisely, it reveals not just mispricings — but misperceptions.

“In markets, value is rarely absolute. It’s always relative — to time, to peers, and to belief.”