Should the valuation process always go through the complex financial calculations behind? What if we do not have the necessary data to forecast the cash flows and the rates involved? We need an easier process then, to identify the value with less information and more quickly.
The answer is ‘Relative Valuation’ – comparing the market prices of similar assets and arriving at a conclusion if the underlying asset is over/under valued. We value an asset based on how the market values the similar assets.
The key here is to identify the similar assets. The general approach is to look at peers in the same industry with similar age, size and risk profile. But if we go back to the definition of valuation – it is dependant on the company’s ability to generate cash flows, its growth rate and risks involved. So it is fine to pick a comparable asset with similar cash flows outside the industry too.
The next step is to identify a metric which would help us compare the prices in a standardised manner. If we are buying a new 3BHK flat in a particular locality, we would not compare it with the prices of individual villas available in the same locality. We would need a common denominator to understand the price point in that market. A useful metric in this case would be – ‘Price per Sq.Ft’ of built area of the properties available and understand if the underlying asset is over/under the market price.
When we are looking at a company’s valuation, a commonly used metric is P/E ratio. It provides an indication of the company’s price/value with respect to it’s earnings potential. The same multiple should be compared with the peers considered in our sample. Firms with negative earnings cannot be compared though, as they don’t have a P/E ratio. Looking at a multiple is a quick and easy way of understand the value/price point.
The methodology would not be suitable for all instances, but would definitely be useful to arrive a quick judgement. The underlying assumption is that the market gets corrected in itself in the longer run.
