Forecasting Company Performance: Relative Valuation Models

"Everything's relative!" is a phrase you sometimes hear to describe various perspectives about life, especially when one perspective is compared to another. And for equity valuation techniques, if it's not absolute valuation, it's a relative valuation model. What do you think a relative valuation model bases its valuation on?

Of course!

No. That's absolute valuation models.

Relative valuation models estimate an asset's value relative to that of another asset. So the main idea is that similar assets should sell at similar prices. That makes the relative valuation model great for companies with no earnings, like a recent IPO. And when you implement a relative valuation model, the focus is on price multiples, such as cash flow per share, or enterprise multiples, such as operating earnings. Why do you think a price multiple like price to earnings is used?

You got it! P/E ratios are easy to use for comparison purposes. For example, if one stock is selling at a lower P/E ratio in comparison to a similar stock, an analyst would say the stock is _relatively_ undervalued. This example highlights how important it is to use caution when comparing relative values because while one stock could be undervalued, the other might be overvalued. So both valuations impact the other. That's why relative-value investing strategies focus on offsetting risks.

Not quite. Price-to-earnings ratios are easy to understand and implement.

No. It's a simple ratio because it involves two inputs.

How do you think traders implement a relative-value strategy?

No. This approach would increase risk in one direction.

Not quite. The net risk here would be neutral if one undervalued stock is sold and another is purchased, so there is no upside.

That's it! By selling the overvalued and buying the undervalued, a trader would have neutral exposure but upside to the undervalued stock appreciating more than the overvalued stock. This relative value investing strategy is called __pairs trading__, which utilizes pairs of closely related stocks by buying the undervalued stock and selling short the overvalued stock.

Another relative valuation method is called the method of comparables, which will use a whole industry or group of comparison assets instead of a single company. This approach is valued for its simplicity and economic rationale that a group of similar assets should trade at similar prices. So as an example, think of Siemens and General Electric, two companies that are in the same industries. For these two, the comparison could be made to the industrial and manufacturing industries to provide a valuation.

To summarize: [[summary]]

Another asset

Discounted cash flows

It's easy to compare

It's hard to understand

It involves numerous inputs

Buy the overvalued, sell the undervalued

Sell the overvalued, buy the undervalued

Buy the undervalued, sell the undervalued

Continue

Continue

Continue