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2012-11-21 09:44:47
February 15 2011| Filed Under Fundamental Analysis, Stock Analysis, Stocks
Relative valuation is a simple way to unearth low-priced companies with strong
fundamentals. As such, investors use comparative multiples like the
price-earnings ratio (P/E), enterprise multiple (EV/EBITDA) and price-to-book
ratio all the time to assess the relative worth and performance of companies,
and to identify buy and sell opportunities. The trouble is that while relative
valuation is quick and easy to use, it can be a trap for investors.
Tutorial: Stock-Picking Strategies
Quick and Easy
The concept behind relative valuation is simple and easy to understand: the
value of a company is determined in relation to how similar companies are
priced in the market. Here is how to do a relative valuation on a publicly
listed company:
Create a list of comparable companies, often industry peers, and obtain their
market values.
Convert these market values into comparable trading multiples, such as P/E,
price-to-book, enterprise-value-to-sales and EV/EBITDA multiples.
Compare the company's multiples with those of its peers to assess whether the
firm is over or undervalued.
No wonder relative valuation is so widespread. Key data - including industry
metrics and multiples - is readily available from investor services like
Multex, Reuters and Bloomberg for a small fee, if not free of charge. In
addition, the calculations can be performed with fewer assumptions and less
effort than fancy valuation models like discounted cash flow analysis (DCF).
(See, Taking Stock Of Discounted Cash Flow.)
Relative Valuation Trap
Relative valuation is quick and easy, perhaps. But because it's based on
nothing more than casual observations of multiples, it can easily go awry.
Consider this: a well-known company surprises the market with exceedingly
strong earnings. Its share price deservedly takes a big leap. In fact, the
firm's valuation goes up so much that its shares are soon trading at P/E
multiples dramatically higher than those of other industry players. Soon
investors ask themselves whether the multiples of other industry players look
cheap against those of the first company. After all, these firms are in the
same industry, aren't they? If the first company is now selling for so many
times more than its earnings, then other companies should trade at comparable
levels, right?
Not necessarily. Companies can trade on multiples lower than those of their
peers for all kinds of reasons. Sure, sometimes it's because the market has yet
to spot the company's true value, which means the firm represents a buying
opportunity. Other times, however, investors are better off staying away. How
often does an investor identify a company that seems really cheap, only to
discover that the company and its business are teetering on the verge of
collapse?
In 1998, when Kmart's share price was downtrodden, it became a favorite of some
investors. They couldn't help but think how downright cheap the shares of the
retail giant looked against those of higher-valued peers Walmart and Target.
Those Kmart investors failed to see that the business's model was fundamentally
flawed. The company's earnings continued to fall and, overburdened with debt,
Kmart filed for bankruptcy in 2002.
Investors need to be cautious of stocks that are proclaimed to be
"inexpensive". More often than not, the argument for buying a supposed
undervalued stock isn't that the company has a strong balance sheet, excellent
products or a competitive advantage. Trouble is, the company might look
undervalued because it's trading in an overvalued sector. Or, like Kmart, the
company might have intrinsic shortcomings that justify a lower multiple.
Multiples are based on the possibility that the market may presently be making
a comparative analysis error, whether overvaluation or undervaluation. A
relative value trap is a company that looks like a bargain compared to its
peers, but is not. Investors can get so caught up on multiples that they fail
to spot fundamental problems with the balance sheet, historical valuations and
most importantly, the business plan.
Do Your Homework
The key to keeping free from relative value traps is extra homework. The
challenge for investors is to spot the difference between companies and figure
out whether a company deserves a higher or lower multiple than its peers.
For starters, investors should be extra careful when picking comparable
companies. It is not enough simply to pick companies in the same industry or
businesses. Investors need also to identify companies that have similar
underlying fundamentals.
Aswath Damadoran, author of the "The Dark Side Of Valuation" (2001), argues
that any fundamental differences between comparable firms that might affect the
firms' multiples need to be thoroughly analyzed in relative valuation. All
companies, even those in the same industries, contain unique variables - such
as growth, risk and cash flow patterns - that determine the multiple. Kmart
investors, for instance, would have benefited from examining how fundamentals
like earnings growth and bankruptcy risk translated into trading-multiple
discounts.
Next, investors will do well to examine how the multiple is formulated. It is
imperative that the multiple be defined consistently across the firms being
compared. Remember, even well-known multiples can vary in their meaning and
use.
For example, let's say a company looks expensive relative to peers based on the
well used P/E multiple. The numerator - share price - is loosely defined. While
the current share price is typically used in the numerator, there are investors
and analysts who use the average price over the previous year. There are also
plenty of variants on the denominator. Earnings can be those from the most
recent annual statement, the last reported quarter, or forecasted earnings for
the next year. Earnings can be calculated with shares outstanding, or it can be
fully diluted, and it can also include or exclude extraordinary items. We've
seen in the past that reported earnings leave companies with plenty of room for
creative accounting and manipulation. Investors must discern on a
company-by-company basis what the multiple means.
The Bottom Line
Investors need all the tools they can get their hands on to come up with
reasonable assessments of company value. Full of traps and pitfalls, relative
valuation needs to be used in conjunction with other tools like DCF for a more
accurate gauge of how much a firm's shares are really worth.
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Ben is the director of Bay of Thermi Limited, an independent research and
consulting firm that specializes in preparing early stage ventures for new
investment and the marketplace. He works with a wide range of clients in the
North America, Europe and Latin America. Ben was a highly-rated European
equities analyst at London-based Old Mutual Securities, and led new venture
development at a major technology commercialization consulting group in Canada.
He started his career as writer/analyst at the Economist Group. Mr. McClure
graduated from the University of Alberta's School of Business with an MBA.
Ben's hard and fast investing philosophy is that the herd is always wrong, but
heck, if it pays, there's nothing wrong with being a sheep.
He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi
Limited at www.bayofthermi.com.