Welcome to Relative Value Equity Valuation!

Have you ever gone shopping for a new phone and thought, "This model costs \$1,000, but the similar one next to it is only \$800. Is the expensive one actually better, or just overpriced?" That is exactly what we do in Relative Value Equity Valuation. Instead of trying to calculate the "true" value of a company from scratch (which we do in DCF models), we compare a company's price to its peers or its own historical performance. It’s practical, fast, and used every single day on Wall Street.

In this chapter, we will master the two main ways to use multiples, learn the "Big Four" price multiples, and understand why Enterprise Value is sometimes better than just looking at the stock price.

1. The Two Main Approaches

There are two ways to decide if a stock's "price tag" (multiple) is fair:

A. The Method of Comparables

This is the most common approach. We compare a company’s multiple (like its P/E ratio) to the multiples of similar companies (peers). If our company has a P/E of 15 and its best competitors have a P/E of 20, our company might be "undervalued"—or there might be a reason it's cheaper. This method is based on the Law of One Price: similar assets should sell for similar prices.

B. The Method of Forecasted Fundamentals

Instead of looking at neighbors, we look at the company's own "DNA." We use a valuation model (like the Dividend Discount Model) to calculate what the multiple should be based on growth rates and risk. This is often called a justified multiple. For example, if our formula says the P/E should be 18, but the market price shows a P/E of 15, the stock is undervalued.

Quick Takeaway: Comparables = "What are others paying?" vs. Fundamentals = "What is it actually worth based on its math?"

2. Understanding Price Multiples

A price multiple is simply a ratio where the numerator is the stock price and the denominator is a financial metric (like earnings or sales). Think of it as: "How many dollars am I paying for every \$1 of [Earnings/Sales/Book Value]?"

The "Big Four" Multiples

1. Price-to-Earnings (P/E) Ratio
\( \text{P/E} = \frac{\text{Price per Share}}{\text{Earnings per Share (EPS)}} \)
This is the "King" of multiples. It tells you how much investors pay for \$1 of profit. High P/E usually means investors expect high growth in the future.

2. Price-to-Sales (P/S) Ratio
\( \text{P/S} = \frac{\text{Price per Share}}{\text{Sales per Share}} \)
Sales are harder to "manipulate" with accounting tricks than earnings. P/S is great for startups that aren't profitable yet.

3. Price-to-Book (P/B) Ratio
\( \text{P/B} = \frac{\text{Price per Share}}{\text{Book Value per Share}} \)
Book value is essentially the company's "net worth" on paper. This is very popular for valuing banks or companies with lots of liquid assets.

4. Price-to-Cash Flow (P/CF) Ratio
\( \text{P/CF} = \frac{\text{Price per Share}}{\text{Cash Flow per Share}} \)
Earnings can be faked; cash flow is reality. Analysts love this because it's harder to distort than the P/E ratio.

Did you know? You can use trailing multiples (using the last 12 months of data) or forward (leading) multiples (using forecasted data for the next 12 months). Markets usually care more about the forward multiple because they are forward-looking!

3. Enterprise Value (EV) Multiples

Sometimes, looking at the stock price alone doesn't tell the whole story because some companies have massive amounts of debt. Enterprise Value (EV) is the "takeover price" of the whole company—it treats the company as if you bought all the stock and paid off all the debt.

The EV Formula:
\( \text{EV} = \text{Market Capitalization} + \text{Total Debt} - \text{Cash and Investments} \)

Why subtract cash? Because if you buy a company for \$100 and it has \$20 sitting in its bank account, the company effectively only cost you \$80.

Common EV Multiple: EV/EBITDA

\( \frac{\text{EV}}{\text{EBITDA}} \)
This is widely used because EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) represents the total flow available to both debt holders and equity holders. It’s great for comparing companies with different levels of debt or different tax rates.

Crucial Rule: Always match the numerator and denominator. If the numerator is Price (Equity only), the denominator must be an "Equity" metric like EPS. If the numerator is Enterprise Value (Equity + Debt), the denominator must be a "pre-interest" metric like EBITDA or Sales.

4. Practical Steps: Peer Group Selection

To use the Method of Comparables, you need a good Peer Group. You can't compare a tech startup to a utility company—that’s like comparing a Ferrari to a tractor!

How to pick peers:

  • Identify companies in the same industry or sub-industry.
  • Look for similar size (market cap).
  • Ensure they have similar growth prospects and risk profiles.
  • Check for similar capital structures (how much debt they use).

Analyst Tip: If a company is a "conglomerate" (operates in many different businesses), it can be very hard to find a perfect peer group. In those cases, analysts often use a "sum-of-the-parts" valuation.

5. Summary & Quick Review

Don't let the formulas overwhelm you. Just remember these core logic steps for the exam:

Common Pitfalls to Avoid:

  • Negative Earnings: You can't use a P/E ratio if the company is losing money (the math breaks!). Use P/Sales instead.
  • Accounting Differences: IFRS vs. US GAAP can make P/E ratios look different even if the companies are identical.
  • The "Cheap" Trap: A low P/E doesn't always mean a bargain. It might mean the company is dying or has huge risks.

Quick Math Checklist:

- Method of Comparables: Price = Benchmark Multiple \( \times \) Company's Fundamental (e.g., Target P/E \( \times \) Company EPS).
- Justified P/E (Forward): Derived from the DDM: \( \frac{P_0}{E_1} = \frac{D_1/E_1}{r - g} \). This shows that the P/E should be higher if the payout ratio is higher, higher if growth (\(g\)) is higher, and lower if risk (\(r\)) is higher.

Final Encouragement: Relative valuation is the most "real-world" part of equity analysis. Master the relationship between Price, Earnings, and Growth, and you'll be well on your way to passing the Equities portion of the Level I exam!