Relative valuation relies on the theory that, in general, similar companies will produce similar results. This may be a bit simplistic, but in a discipline that involves a lot of assumptions and estimates, relative valuation is popular among analysts as it provides a way to arrive at the value of a business that is plausible, quick, and simple. The actual calculations are simple and straightforward; the difficulty is in identifying comparable companies.
The main criteria to consider are as follows:
- Industry
- Size
- Capital structure
- Geographical location
- Growth rate
Industry: With reference to your major source of income, identify the appropriate industry to which the company belongs and look for examples within that industry class.
Size: The relationship between size and profits is not exactly linear. A company with twice the asset base will not necessarily make twice as much profit. There may be economies of scale and access-restricted benefits as a result of its size. Large companies will have access to volume discounts and favorable business terms not available to smaller companies in the same industry. You should therefore look for companies that are similar in size.
Capital structure: A company that relies heavily on debt puts its shareholders at greater risk. This is because debt holders must always be settled before equity holders—for example, in the event of bankruptcy. In addition, companies that are heavily geared will have to maintain a healthy interest cover ratio in order to maintain their creditworthiness. You should look for companies with similar debt-to-equity ratios.
Geographical location: This is very important as location can have a significant effect on a company's operations. The economic climate, tax, tariffs, and other relevant legislation could differ, and this could have a significant effect on the bottom line. You should look for companies within the same geographical location.
Growth rate: A company that grows fast will be more attractive to potential investors than one with a slower growth rate. You should therefore look for companies with a similar growth rate. It will be impossible to find companies that meet all these criteria, and therefore you will have to use your own judgement to select those that are most similar to the company you are modeling. Once you have identified four or five companies, you will then need to obtain a number of multiples, which will be used in your comparative valuation.
The most common multiples used for this purpose are as follows:
- EV/Sales—Enterprise value by Sales
- EV/EBITDA—Enterprise value by EBITDA
- P/E—Price-to-earnings ratio
The idea is that similar companies will have similar multiples. So, if EV/Sales=K for company A, then the same multiple for a similar company, company B, will also be = K.
Taking company A:
EV / Sales = K
Taking Sales to the right-hand side to isolate EV, we get the following:
EV = K × Sales
So, once we have Sales for company B, we can calculate EV by adopting the same multiple, K from company A.
In practice, the multiples for four or five similar companies you identify will never be exactly the same, so you will take the mean (average) or median as the common multiple, K.