What Is a Relative Valuation Model?
A relative valuation model is essentially the financial world’s version of keeping up with the Joneses. Instead of pining over your neighbor’s new sports car, here you’re assessing whether a company’s stock price is street-legal or speeding towards an overvaluation pit stop, all by comparing it to how its industry buddies are doing.
How Relative Valuation Models Work
Think of the stock market as a high school reunion: everyone shows up, some in luxury, and others on a budget. The relative valuation model is like bringing a scorecard to this reunion to see who has aged most profitably. This model uses various ratios, such as the Price-to-Earnings (P/E) ratio, possibly the Homecoming King of financial indicators. It calculates how much investors are willing to pay for a dollar of earnings in comparison to similar companies.
Relative Valuation Model vs. Absolute Valuation Model
The showdown between relative and absolute valuation models is like choosing between asking your friend if you look good, or looking in the mirror. Relative valuation asks around, using industry averages as a mirror. Absolute valuation doesn’t wander for opinions; it uses intrinsic value based solely on its own fundamental outlook—like calculating how much that new kitchen really adds to your house’s resale value without peeking at your neighbor’s renovations.
Assumptions of Relative Valuation Models
Setting up a relative valuation model involves certain assumptions:
- Businesses in the same industry face similar economic and market conditions; hence, a comparison makes sense.
- The metrics used to measure valuation should be universally applicable within an industry—think of it as a standardized test for valuing companies.
Real Life Examples of Relative Valuation
Let’s say you’re looking at two coffee shops:
- Coffee Shop A has a P/E ratio of 15, which means the market pays $15 for every $1 of earnings.
- Coffee Shop B has a P/E ratio of 10. Simple math tells you that compared to Shop B, Shop A might just be an espresso shot too expensive unless it has some mocha-secret sauce worth the extra bucks.
Related Terms
- P/E Ratio: The most guest-listed ratio at financial parties. It compares a company’s current share price to its per-share earnings.
- Enterprise Value (EV): Total valuation of a company, including debts, minus cash on hand. Think of it as calculating the true cost of buying out a company, flush with all its financial obligations.
- Market Capitalization: The total market value of a company’s outstanding shares. It tells you how big the company is in terms of market presence.
Further Reading
- “The Little Book of Valuation” by Aswath Damodaran - A compact guide to understanding all crinkles of valuation, both absolute and relative.
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc. - This book dives deep into the nuances of valuation, making it suitable for both budding and seasoned investors.
In conclusion, using a relative valuation model doesn’t mean you blindly follow the financial herd; it’s about smart comparison shopping in the vast market aisle, making sure you buy the best bang for your buck—or in Wall Street speak, the most earnings for your share.
