Understand relative - comparable valuation — Stock-Market notes

Intuition Core Intuition: The "Real Estate Apraisal" Method

Imagine you're selling your house. You don't build a complex cash-flow model of future rent income. Instead, you look at similar houses in your neighborhood that recently sold. If3-bedroom houses on your street sold for $500K, yours is probably worth around that too.

That's relative valuation: value a company by comparing it to similar companies using simple ratios (multiples). If similar tech companies trade at 15× earnings, and your company earns $10M, it's worth roughly$ 150M. Why it works: Markets are collective intelligence. If investors pay certain prices for Company A, they'll pay similar prices for Company B if they're truly comparable. The market does the heavy lifting of valuation for you.

What is Relative Valuation?

WHY Relative Valuation Exists

Fundamental reason: Absolute valuation (DCF, DDM) requires:

10+ years of cash flow forecasts (highly uncertain)
Terminal growth rates (nobody knows)
Discount rates (subjective WACC calculations)

Relative valuation says: "I don't know the'true' intrinsic value, but I know this company should be priced like those companies."

Practical advantages:

Speed: Calculate 5 multiples in 30 minutes vs. 8-hour DCF model
Market-Grounded: Reflects current investor sentiment, not theory
Easy Communication: "We trade at 12× earnings vs. 18× for peers" is instantly clear

The tradeoff: You inherit market mis-pricing. If the whole sector is overvalued, your valuation will be too.

The Key Valuation Multiples

Figure — Understand relative - comparable valuation

1. Price-to-Earnings (P/E) Ratio

Formula P/E Ratio Derivation

What we want: How much investors pay per dollar of earnings.

$\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}$ Why this form?

Numerator (Price): What you PAY to own the company
Denominator (Earnings): What the company PRODUCES for you annually
The ratio: "I pay $15 to get$ 1 of annual profit" → P/E = 15×

Alternative form (for whole company): $\text{P/E} = \frac{\text{Market Capitalization}}{\text{Net Income}}$

Derivation from first principles: Start with Gordon Growth Model: $P_0 = \frac{D_1}{r-g}$

Dividend payout ratio: $\text{Payout} = \frac{D_1}{EPS_1}$

So $D_1 = \text{Payout} \times EPS_1$

$\frac{P_0}{EPS_0} = \frac{\text{Payout} \times EPS_1}{(r-g) \times EPS_0} = \frac{\text{Payout} \times (1+g)}{r-g}$

Insight: P/E ratio increases with:

Higher payout ratio (more dividends)
Higher growth rate $g$
Lower required return $r$ (less risky)

When to use P/E:

✅ Mature, profitable companies (banks, consumer goods)
❌ Loss-making companies (negative earnings make P/E meaningless)
❌ Capital-intensive businesses (depreciation distorts earnings)

Worked example P/E Multiple Valuation

Setup: You're valuing a retail company "ShopC" with Net Income = $50M.

Step 1 - Select Comparables: Find 4similar retailers:

Retailer A: Market Cap $800M, Net Income$ 40M → P/E = 20×
Retailer B: Market Cap $1.5B, Net Income$ 100M → P/E = 15×
Retailer C: Market Cap $600M, Net Income$ 30M → P/E = 20×
Retailer D: Market Cap $2B, Net Income$ 80M → P/E = 25× (fast-growing e-commerce)

Step 2 - Calculate Median Multiple: P/E ratios: 20×, 15×, 20×, 25× Median = 20× (we use median, not mean, to avoid outlier distortion)

Step 3 - Apply to ShopCo: $\text{Implied Market Cap} = \text{Net Income} \times \text{P/E Multiple}$ $= \$50M \times 20 = \$1,000M = \$1B$

Why this step? We assume investors will value ShopCo's $1 of earnings the same as peers'$ 1 of earnings.

Sanity check: If ShopCo is growing slower than peers, maybe use 18× (10% discount). If faster, maybe 22×.

2. Enterprise Value to EBITDA (EV/EBITDA)

Formula EV/EBITDA Derivation

Problem with P/E: Two identical businesses can have different P/E if one uses debt, one doesn't (interest expense reduces earnings).

Solution: Use Enterprise Value (EV) — the value of the ENTIRE business — and EBITDA (earnings before interest, tax, depreciation, amortization) — operating profit ignoring capital structure.

$\text{EV/EBITDA} = \frac{\text{Enterprise Value}}{\text{EBITDA}}$ Building blocks: $\text{Enterprise Value (EV)} = \text{Market Cap} + \text{Debt} - \text{Cash}$ Why? EV is the "takeover price":

You buy all shares (Market Cap)
You inherit the company's debt (+ Debt)
You get the company's cash (- Cash)

$\text{EBITDA} = \text{Net Income} + \text{Interest} + \text{Taxes} + \text{Depreciation} + \text{Amortization}$

Why? EBITDA removes:

Interest: Financing decision (debt vs equity)
Taxes: Jurisdiction differences
D&A: Accounting choices, not real cash What EV/EBITDA tells you: "I pay 8× the company's annual operating profit to buy the whole business."

When to use EV/EBITDA:

✅ Comparing companies with different capital structures
✅ Capital-intensive industries (telecom, manufacturing)
✅ M&A analysis (acquirers care about EV, not just equity)
❌ Banks/financial firms (debt is their product, not financing)

Worked example EV/EBITDA Valuation

Setup: Valuing a manufacturing company "FactoryCo" with EBITDA = $80M.

FactoryCo's balance sheet:

Debt: $200M
Cash: $50M Step 1 - Comp EV/EBITDA multiples:
Manufacturer A: EV $1.2B, EBITDA$ 150M → 8×
Manufacturer B: EV $800M, EBITDA$ 100M → 8×
Manufacturer C: EV $1.5B, EBITDA$ 200M → 7.5×

Median = 8×

Step 2 - Implied EV: $\text{EV} = \text{EBITDA} \times \text{Multiple} = \$80M \times 8 = \$640M$

Step 3 - Back out Equity Value: $\text{Market Cap} = \text{EV} - \text{Debt} + \text{Cash}$ $= \$640M - \$200M + \$50M = \$490M$

Why this step? EV is the whole pie. To find equity value, subtract what's owed to debt holders, add cash they don't claim.

If FactoryCo has 50M shares outstanding: $\text{Implied Share Price} = \frac{\$490M}{50M} = \$9.80$

3. Price-to-Sales (P/S) Ratio

Use case: SaaS companies, biotech (pre-profit), retailers

4. Price-to-Book (P/B) Ratio

Use case: Banks, insurance, real estate (asset-heavy businesses)

The Critical Step: Selecting Comparables

Control Premium

If valuing for acquisition: Add control premium (20-40%) because buyer can:

Replace management
Cut costs
Extract synergies

Comparable multiples reflect minority stakes (passive shareholders). Acquirers pay more.

Normalization

Adjust for one-time events:

Remove restructuring charges from EBITDA
Exclude lawsuit settlements from net income
Adjust for unusual working capital swings

Advantages and Limitations

Advantages:

Market-Based: Reflects current sentiment and information
Quick: Can value a company in hours
Intuitive: Easy for non-finance people to understand
Flexibility: Multiple metrics (P/E, EV/EBITDA, P/S) for different situations

Limitations:

Garbage In, Garbage Out: If comps are mispriced, your valuation inherits the error
Finding True Comps is Hard: Especially for unique businesses (Amazon in2005?)
Ignores Company-Specific Factors: Doesn't capture unique competitive advantages
Market Mood Swings: In bubles, all multiples expand; in crashes, all contract

Combining with Other Methods

Recall Explain Like I'm 12: The Lemonade Stand

Imagine you and4 friends all run lemonade stands on different street corners. You want to know what your stand is worth.

You could count every cup you might sell for the next 10 years (really hard and you'd probably be wrong).

OR you could look at what people paid for your friends' stands:

Sarah's stand makes $100/summer → sold for$ 500 (5× earnings)
Mike's stand makes $200/summer → sold for$ 1,000 (5× earnings)
Your stand makes $150/summer

Probably worth: $150 × 5 =$ 750!

That's relative valuation. You're saying "My stand should be worth the same multiple as similar stands."

The tricky part: What if Sarah's stand is on a busier street? Or Mike's sells fancy organic lemonade for higher prices? Then they're not really comparable. You need to find stands that are TRULY similar to yours.

That's why picking good comparables is the hardest (and most important) part!

Connections

2.6.01-Introduction-to-valuation-methods — Relative valuation as one of three core approaches
2.6.04-Understand-absolute-valuation-DCF — How relative valuation complements DCF
2.6.06-Apply-valuation-to-stock-selection — Using multiples for screening and comparison
Financial-Ratios — P/E, P/B as key profitability and value metrics
Market-Efficiency — Why comparable pricing works (if markets are semi-efficient)

#flashcards/stock-market

What is relative valuation and what does it compare? :: Relative valuation estimates a company's worth by comparing it to similar publicly-traded companies using valuation multiples (ratios of market value to financial metrics). It compares similar businesses that should trade at similar multiples.

What are the three steps of comparable company analysis?

1) Select truly similar comparable companies 2) Calculate valuation multiples (P/E, EV/EBITDA, etc.) for the comps 3) Apply the comp multiples to value your target company.

Write the P/E ratio formula and explain what it measures.

P/E = Market Price per Share / Earnings per Share (or Market Cap / Net Income). It measures how much investors pay per dollar of earnings. A P/E of 15× means you pay

15 to get

1 of annual profit.

What is Enterprise Value (EV) and how is it calculated?

EV is the total value of a business (the "takeover price"). EV = Market Cap + Debt - Cash. It represents what you'd pay to acquire all shares plus inherit debt, minus cash you'd receive.

Write the EV/EBITDA formula and explain why it's better than P/E for some comparisons.

EV/EBITDA = Enterprise Value / EBITDA. It's better for comparing companies with different capital structures because EV includes debt and EBITDA removes interest expense, making it capital-structure neutral.

What is EBITDA and why do we use it?

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization. We use it because it represents operating profit before financing decisions (interest), jurisdiction differences (taxes), and accounting choices (D&A).

When should you use P/S ratio instead of P/E ratio?

Use P/S (Price-to-Sales = Market Cap / Revenue) for young companies with negative earnings, where P/E is meaningless, or when revenue is less manipulated than earnings. Common for SaaS and pre-profit companies.

What does P/B ratio measure and when is it most useful?

P/B = Market Cap / Book Value of Equity. It compares market value to accounting value. Most useful for asset-heavy businesses like banks, insurance, and real estate. P/B < 1 suggests market thinks assets are worth less than stated.

What five factors must comparable companies match on?

1) Business model 2) Growth rate (±5%) 3) Profit margins 4) Size/scale 5) Geography. These ensure the companies are truly comparable and would command similar multiples from investors.

Why can't you just use the median multiple as the final answer?

The median is only a starting point. You must adjust for quality differences (management, brand), growth differences (faster growth → higher multiple), and risk differences (lower risk → higher multiple). Justify a±10-20% adjustment with reasoning.

What is a control premium and when do you add it?

A control premium (20-40%) is added when valuing for acquisition. Buyers pay more than market prices because they can replace management, cut costs, and extract synergies. Comparable multiples reflect minority stakes, not control positions.

What is normalization in relative valuation?

Normalization adjusts financial metrics for one-time events (restructuring charges, lawsuit settlements, unusual gains) to reflect sustainable, recurring performance. This makes multiples more comparable across companies.

What are three main advantages of relative valuation?

1) Market-based (reflects current sentiment and information) 2) Quick (hours vs days for DCF) 3) Intuitive (easy to communicate "we trade at 12× vs 18× for peers").

What are three main limitations of relative valuation?

1) Garbage in, garbage out (inherits market mispricing) 2) Finding true comps is hard (especially for unique businesses) 3) Ignores company-specific factors (doesn't capture unique competitive advantages).

Why should you use multiple valuation methods, not just one?

Value is a range, not a single number. Using DCF (intrinsic), relative valuation (market comparables), and precedent transactions creates triangulation. If all converge, you have high confidence. If they diverge, investigate why to understand risk/opportunity.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Dekho, relative valuation ka core idea bilkul simple hai — jaise apni ghar bechte time tum poora hisaab-kitaab nahi karte, balki apne mohalle mein recently jo similar ghar bike hain unka price dekhte ho, waise hi ek company ki value nikalne ke liye hum similar companies se compare karte hain. Multiples yaani ratios use hote hain, jaise P/E (Price-to-Earnings). Matlab agar market mein waise hi tech companies 15× earnings pe trade kar rahi hain, aur tumhari company 10M kama rahi hai, toh uski value roughly 150M hogi. Simple, na? Market khud hi collective intelligence ki tarah kaam karta hai — agar investors Company A ke liye ek certain price de rahe hain, toh truly similar Company B ke liye bhi wahi denge.

Yeh method matter kyun karta hai? Kyunki absolute valuation (jaise DCF ya DDM) mein tumhein 10+ saal ke cash flows predict karne padte hain, terminal growth rate guess karna padta hai, aur discount rate bhi subjective hota hai — bahut uncertainty aur mehnat. Relative valuation bolta hai — "Mujhe exact intrinsic value nahi pata, par mujhe pata hai ki yeh company un companies jaisi price honi chahiye." Iska fayda yeh ki tum 30 minute mein 5 multiples nikaal sakte ho, yeh current market sentiment reflect karta hai, aur communicate karna bhi easy hai — "hum 12× earnings pe trade kar rahe hain jabki peers 18× pe" — instantly clear.

Bas ek tradeoff yaad rakhna: agar poora sector hi overvalued hai, toh tumhari valuation bhi overvalued aa jayegi, kyunki tum market ki mis-pricing inherit kar lete ho. Aur P/E ka use samajh-soch ke karo — mature aur profitable companies (banks, consumer goods) ke liye achha hai, par loss-making companies ke liye bekaar (negative earnings se P/E meaningless ho jaata hai). Steps yaad rakho: pehle sahi comparables select karo, phir unke multiples calculate karo (jaise median nikaalo), aur phir apni target company pe apply karo. Practice karoge toh yeh method tumhara sabse fast valuation tool ban jayega!

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