What it means
Think of how a property agent prices a house. She looks at similar homes recently sold nearby, adjusts for size and condition, and arrives at a sensible price.
A relative valuation model does the same for companies, using peers as the reference points. The analyst starts by choosing a peer group of businesses with similar size, growth, risk and industry.
Next, they compute a multiple for each peer, such as enterprise value to EBITDA (EV/EBITDA, where EBITDA means earnings before interest, tax, depreciation and amortisation). Finally, they apply the peer median multiple to the target company's own figure to get an implied value.
Common multiples include P/E, price-to-sales, price-to-book and EV/EBITDA, and the right choice depends on the sector. Software firms are often compared on revenue multiples because many have thin profits, while mature manufacturers are compared on EBITDA.
Banks are usually compared on price-to-book. The method is popular in mergers and acquisitions, fundraising, initial public offerings and fairness opinions, because everyone can see where the numbers came from.
Its weakness is that it assumes the market has priced the peers correctly. If the whole sector is overvalued, the model will produce an overvalued answer without any warning.
For this reason, careful analysts treat relative valuation as a cross-check against a discounted cash flow (DCF, a valuation based on future cash flows) rather than a replacement. A range of values across several multiples is more honest than a single figure.
Adjustments make the answer more credible. Analysts often apply a discount to a private company because its shares are harder to sell, and a premium in an acquisition because the buyer gains control.
These adjustments should be stated openly, since they can move the value by 10% to 30% and are easy to hide inside a single headline number.
In practice
Real-world examples.
Example
An investment banker advises a family-owned packaging firm preparing for sale. She selects six listed packaging companies, calculates their median EV/EBITDA, and applies it to the family firm's earnings to set an asking range. The buyers can verify the logic easily, which speeds up negotiations.
Example
A start-up founder preparing for a funding round sees that listed software companies trade at about 6 times annual revenue. With $5,000,000 of recurring revenue, he proposes a valuation around $30,000,000, then discounts it to reflect his company's smaller scale. Investors counter with a lower multiple, and the negotiation is about the multiple, not the model.
Example
A corporate development analyst at a retailer tests whether a takeover offer is fair. She finds that the target trades at 11 times earnings against a peer median of 14, which suggests the shares are cheap compared with rivals. The board uses this to argue for a higher bid.
Formula
Calculation
Implied enterprise value = Peer multiple x Target metric
Implied equity value = Implied enterprise value - Net debt
Suppose a target company has EBITDA of $20,000,000, and comparable companies trade at a median of 8 times EBITDA. Implied enterprise value = 8 x 20,000,000 = $160,000,000. The company has net debt of $40,000,000, so implied equity value = 160,000,000 - 40,000,000 = $120,000,000. With 10,000,000 shares outstanding, the implied value per share is 120,000,000 / 10,000,000 = $12.Case study
Seen in the real world.
Oakridge Dental Group is an illustrative, fictional chain of 40 clinics weighing an offer from a larger operator. The board asked its advisers whether the price was fair.
The advisers built a peer group of five listed healthcare services companies and found a median EV/EBITDA of 9 times. Oakridge's EBITDA was $15,000,000, so the relative valuation implied an enterprise value of $135,000,000, compared with the $108,000,000 on offer.
The board used the comparison to push back, while accepting the advisers' warning that Oakridge was smaller and less diversified than the peers. After negotiation, a compromise price of $120,000,000 was agreed, and the illustrative lesson was that peer multiples frame a negotiation without settling it.
Watch out
Common mistakes.
- Picking peers that look similar on the surface but differ sharply in growth, risk or size, which makes the multiple unreliable.
- Applying an enterprise value multiple and forgetting to subtract net debt, so that debt-holders' claims are counted as value for shareholders.
- Treating the result as a precise answer, when it is a range that depends on the market mood on the day.
Questions
People also ask.
Which multiple should I use?
Choose the one that matches how the industry is usually valued, such as EV/EBITDA for mature industrial businesses or price-to-sales for fast-growing firms with thin profits.
Is relative valuation better than a discounted cash flow?
Neither is better in all cases: relative valuation reflects what the market pays today, while a DCF reflects the company's own fundamentals, so most analysts use both.
What if there are no good peers?
Use a wider group and adjust for differences, or fall back on transaction multiples from past acquisitions, and make clear that the answer is less reliable.
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