Bloomberg - Relative Valuation

A valuation is a process that helps determine a company's price.

There are two ways to determine the value of company:

a) absolute valuation

b) relative valuation.

In reality, it is hard to set the correct price for a company because it's cost is influenced by many factors.

• Every valuation is subjective as it depends on projected future growth which is hard to determine
• While absolute valuation focuses on finding out the price of any company with the use of formulas, relative valuation compares one company to another within the same industry.
• The objective of relative valuation is to find out if one company is under or over-valued relative to its peers.
• In the end, relative valuation relies both on intrinsic value and actual company prospects.

Common metrics we can use in relative valuation are:

• price to earnings ratio
• return on equity
• operating margin
• enterprise value
• price to free cash flow

This chart provides you with a comparison between absolute and relative valuation.

The main advantage of absolute valuation is that the final result is more precise as it is based on actual numbers of the given company rather than feelings.

On the other hand, relative valuation is far more simple, key features are price to earnings or dividend payout comparison of one company to another.

Yet absolute valuation has drawbacks in its complexity and it can also be easily misinterpreted with the work of a skilled accountant that can mislead company free cash flow.

Relative valuation has negative sides in the fact that it can be hard to find two firms to compare as no company is the same. Furthermore, when you are comparing one company to another, you are assuming that the comparative company is fairly valued, but that may be false.