Relative valuation

Relative valuation involves using similar assets to value another asset.

One common example is in real estate, where prospective buyers will use the value of other properties of a similar size in the same area to determine the amount they are willing to offer for a particular property.

Relative valuation is proven for a range of assets every day – as fundamental issues are often relevant across sectors, or even markets, assets within those sectors or markets often move in tandem.

If we use share trading as an example, some of the common factors used to measure stock value include:

1.    Price to earnings ratio
2.    Return on equity
3.    Operating margin
4.    Enterprise value
5.    Price/cash flow per share

Example

Westpac and the Commonwealth Bank (CBA) are Australia’s two largest banks. On September 26, CBA shares were priced at AUD43.89, while Westpac shares were AUD19.11. CBA has a market capitalisation of AUD69 million and Westpac has a market capitalisation of AUD57 billion.

A share trader can use this information to determine whether investing in CBA or Westpac would be better value. Both companies’ market capitalisations are very similar, along with their enterprise values, so we’ll focus on the price to earnings ratio, return on equity and operating margin.

Although Westpac has a lower price to earnings ratio, the CBA has a higher return on equity despite having a lower operating margin. CBA also has a higher cash flow per share than Westpac and if it can continue churning higher cash flow, it’s a sign that it is creating more value from shareholders.

Limitations

Although relative valuations have their benefits, they also have their limitations. The greatest limitation is when the market has valued a business incorrectly – in the case of a bubble, it wouldn’t matter what either companies’ fundamentals were.

Also, company valuations are based on past performance, and future performance is what drives stock prices. Relative valuation accounts for the current and past value of a share, rather than future growth.

That being said, relative valuation is a simple tool that any trader can add to his arsenal, and the information required to perform your own evaluation is readily available.