Relative Valuation Model

Overview

A relative valuation model estimates a company’s value by comparing it to similar businesses using market-based multiples and ratios. Instead of calculating intrinsic worth from first principles, it answers: how does the company trade relative to its peers? This approach helps determine whether a stock appears overvalued, undervalued, or fairly priced in the context of its industry.

Key takeaways

• Relative valuation uses market multiples (e.g., P/E, EV/EBITDA, P/S) to compare companies.
• It reflects current market sentiment and is quick to apply with readily available data.
• Its usefulness depends on selecting appropriate comparable companies and the right ratios.
• Best used alongside absolute valuation methods (like DCF) to form a fuller view.

How it differs from absolute valuation

Absolute valuation methods (such as discounted cash flow) estimate intrinsic value based on a company’s expected future cash flows and fundamental assumptions. Relative valuation sidesteps those forecasts and instead benchmarks a company against peers’ market prices. Analysts commonly use both: absolute methods for fundamental insight and relative methods to validate or calibrate market-based expectations.

Common metrics and what they reveal

Choose metrics that reflect how investors value companies in the target industry.

• Price-to-Earnings (P/E): Price per share divided by earnings per share. Useful for mature, profitable firms; higher P/E implies investors pay more per dollar of earnings.
• Enterprise Value / EBITDA (EV/EBITDA): Enterprise value divided by operating earnings before non-cash charges. Useful for comparing firms with different capital structures.
• Price-to-Sales (P/S): Market cap divided by revenue. Helpful for early-stage or unprofitable companies.
• Price-to-Cash-Flow (P/CF): Price divided by cash flow per share; useful when accounting measures differ from cash generation.
• Price-to-Book (P/B): Market price relative to book value; often used in banking and asset-heavy industries.
  Select the ratio(s) that best capture the value drivers in the sector being analyzed.

Steps to perform a relative valuation

1. Identify comparables: select companies with similar business models, size, growth profile, and geography.
2. Choose relevant multiples: pick metrics commonly used in the industry and appropriate to the target’s financial profile.
3. Calculate ratios: compute the selected multiples for the target and each comparable.
4. Compare and adjust: examine the range, median, and mean of peer multiples. Apply a representative multiple to the target’s metric (e.g., revenue or EBITDA) and adjust for differences in growth, margins, or risk.
5. Interpret: determine whether the target is trading at a premium or discount and investigate reasons for discrepancies (e.g., structural advantages, one-time issues, or market mispricing).

Types of relative valuation approaches

• Market multiple models: apply an average peer multiple to the target’s financial metric to estimate value (simple and quick).
• Comparable company analysis (CCA): present a side-by-side table of multiples to show the target’s position within the peer range and derive a fair-value band.
• Precedent transactions analysis: use multiples paid in past acquisitions of similar companies; often includes control premiums and typically produces higher estimates than trading multiples. Useful for M&A context.

Advantages

• Simplicity and speed — fewer assumptions than intrinsic models.
• Market relevance — reflects how investors currently price similar assets.
• Useful benchmark — highlights relative premiums or discounts and can validate other valuation outcomes.

Limitations

• Dependent on finding true comparables — differences in size, growth, accounting, or business mix can skew results.
• Can propagate market mispricing — a bubble or depressed sector will bias the analysis.
• Limited forward-looking insight — provides a snapshot based on current market data and does not replace detailed fundamental forecasting.

Bottom line

Relative valuation is a practical, market-focused tool for assessing how a company stacks up against peers. It is most effective when the analyst carefully selects comparable firms and appropriate multiples, and when results are interpreted alongside absolute valuation techniques and qualitative judgment. Used together, these methods provide a more complete picture of a company’s potential value.