Relative Valuation Part 1-Introduction

Relative Valuation Part 1-Introduction

This column is written by @gordon_ong

-Gordon has a demonstrable interest in equity investments, financial markets, and negotiating deals. As @NTUInvestmentClub president, he has an understanding of what factors drive an organisation’s success.

What is Relative Valuation? Relative Valuation is a quick way to compare assets to the price of similar assets in the market. Multiples are just standardised estimates for the value of the company. Just like you compare data plans between Telecoms, relative valuation compares the company price to what you are getting in return (e.g. revenue, earnings, dividends, cash flow, book value, etc). To compare between data plans, you may come up with a multiple called Price (per month)/Data to see which data plan is the most value-for-money.

Relative Valuation assumes that the factors not captured by the multiple either are of little consequences, or balance each other out on average. For example, the Price/Data does not capture the other benefits of the data plan, such as Calls, Free SMS etc. This may be relevant or it may not. These auxiliary benefits might mean nothing to you as you exclusively use network services for messaging (e.g. Whatsapp, Wechat, FB messaging) and Voice-over-IP such as Skype or FB calls, in which case Price/Data is a good way for you to decide which plan to sign for. On the other hand, you may prefer making phone calls normally, in which case, Price/Data does not reflect the benefit that you gain from the plan.

Other complexities involve the non-linearity of relationship and law of diminishing returns – Price/Data is not a linear relationship. You are willing to pay more to bump up your data from 1MB to 2MB, but if you already have 16MB, is adding an additional 1MB worth paying more? Moreover, although Price/Data dictates that you should buy Starhub plan, your consumption patterns may not be able to live with 4MB per month!

You might also believe that Starhub’s data coverage is better than Singtel’s, so you are willing to value each Starhub MB at a premium.
All these concerns apply directly to stocks.

Any two-factor ratio is likely to omit information about the company that you, the investor, consider very important to the investment decision. For starters, P/E does not adjust for capital structure, and P/BV does not tell you whether the composition of your book value is tangible or intangible. Furthermore, whether to consider these omitted factors is up to the investor’s personal preference: you may not mind debt-fuelled growth if it is properly managed and accompanied with a low P/E.

Overvaluation and undervaluation are measured in percentages, not raw numbers: a P/E difference of 5 may look the same, but it is better that your company trades at P/E 10 and industry 15 (33% discount), than your company trades at P/E 15 and industry 20 (25% discount).

Certain numbers are also more ‘valuable’ if the company is operating differently from its peers – that again boils down to comparing similar assets, and being very aware of any differences. For example, two companies have the same Enterprise Value and Revenue, but one company is more efficient and is better able to convert its Revenue to Net Profit (higher net profit margin). However, the multiple “EV/Revenue” indicates the same number! Clearly, the multiple does not show the company’s advantage. It is important to know what your company does differently to your comparable companies, as well as some of the industry-specific multiples, in order to select the correct multiple for comparison.

1) What are the ways of comparison? Here are some of them grouped into groups:

2) What qualifies as a comparable?

A comparable must be a similar asset. For some types of assets, that intuitively makes sense. Petrol with the same Octane Rating are literally the same – it makes sense to go for the cheapest! Academically speaking, they must have similar growth, risk and cashflow characteristics. However, practically speaking (especially on SGX), it is nigh impossible to find such a perfect comparable company. Hence, we include companies that are from the same industry and geographical location, similar business model and business segments, similar levels of revenue and market capitalisation, and (preferably) similar historical growth rates and margins. Using some multiples, we can even adjust for the effect of different capital structures.

3) What does a multiple consist of?

Embedded within every multiple are all the variables that drive the DCF valuation – growth, risk and reinvestment requirements. Fundamentals have a clear relationship with the multiple, but not a linear one. A company with twice the growth rate does not trade at twice the P/E multiple. I will talk more about this when covering individual multiples.

Now that I have explained the rationale behind Relative Valuation, next posts will cover a few ratios such as P/E, P/B, EV/EBITDA etc. I will also explain the capital structure, the difference between firm valuation and equity valuation, and the need to match numerator and denominator for accurate multiples.

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