How to do the Relative Valuation of Stocks? Basics of Stock Valuation!

Understanding how to do the relative valuation of stocks: Stock valuation is one of the most important aspects to analyze before investing in any share. You might be able to find a good company, however, if you not evaluating its valuation correctly and entering at an inflated price, then it might turn out to be a bad investment.

“A great company is not a great investment if you pay too much for the stock.“ — Benjamin Graham, father of value investing.

In this article, we’ll discuss how to do stock valuation using the relative valuation of stocks approach. Keep Reading.

Basics of Stock Valuation

There are two basic approaches to find the valuation of stocks: 1) Absolute Valuation Approach and 2) Relative valuation Approach.

The absolute valuation tries to determine the intrinsic value of the company based on the estimated profits and free cash flows discounted to their present value. It is a little difficult approach to find the valuation of stocks as it involves financial calculations and assumptions like the growth rate of the company for the next 5–10 years, discount rate, etc.

The Discounted Cash Flow model (DCF) is the most common approach for absolute valuation.

However, the major limitation of using absolute valuation is that the results are only as good as inputs as you will require to make many assumptions. This article is not focused on absolute valuation. You can read this post to understand absolute valuation with financial terms like future free cash flow projections, discount rate (weighted average cost of capital- WACC), etc find the estimated true value of a company.

Relative Valuation is a comparatively faster and easier approach to value stocks. Today, we are going to discuss how to do the relative valuation of stocks.

Relative Valuation of Stocks

Relative valuation of stocks is an alternative to absolute valuation. It is an easier approach to determine whether a company is worth investing in or not. Relative valuation compares the company’s financials to that of its competitors, industry average, or historical performance to find the company’s financial position.

It’s similar to comparing the different houses in the same locality to find the worth of a house to invest in. Let’s say if most of the 3BHK apartment in the same locality costs around 70 lakhs and you are able to find a similar 3 BHK apartment which costs 50 lakhs, then you can consider it cheap and undervalued.

Here, your approach is not to find the true worth of the apartment but just to compare its price with similar competitors to find whether it is over or under-valued.

Tools to Perform Relative valuation of stocks

There are a number of tools or financial ratios that you can use to do the relative valuation of the Indian stocks. A few of the most common financial ratios that you should definitely know to perform a relative valuation of stocks are described below:

1. Price to earnings (PE) ratio

This is one of the most popular financial ratios used to perform the relative valuation of stocks, used by investors all across the world. It tells us how much investors are willing to pay to buy that share compared to its earnings. A high PE ratio generally shows that the investor is paying more for the share. The PE ratio is calculated using this formula:

Price to Earnings Ratio= (Price Per Share)/( Earnings Per Share)

As a thumb rule, a company with a lower PE ratio compared to its competitors is considered under-valued compared to another company in the same sector with a higher PE ratio. However, the average PE ratio value varies from industry to industry, therefore always compare the PE of companies only in the same industry.

2. Price to Book Value (PBV) Ratio

The book value is referred to as the net asset value of a company. It is calculated as total assets minus intangible assets (patents, goodwill) and liabilities. The price to Book Ratio (PBV) is calculated by dividing the current price of the stock by the book value per share. Therefore, it can be calculated using this formula:

Price to Book Ratio = (Price per Share)/( Book Value per Share)

PBV ratio is an indication of how much shareholders are paying for the net assets of a company. Generally, a lower PBV ratio could mean that the stock is undervalued. As a thumb rule, companies with lower PBV ratio is undervalued compared to the companies with higher PBV ratio. In addition, the Price to Book Value Ratio should be compared only with the companies in the same industry.

3. Price to Sales Ratio

The Price to Sales Ratio (P/S) ratio measures the price of a company’s stock against its annual sales. P/S ratio is another stock valuation indicator similar to the P/E ratio.

Price to Sales Ratio = (Price per Share)/(Annual Sales Per Share)

A P/S ratio is a great tool because sales figures are considered to be relatively reliable while other income statement items, like earnings, can be easily manipulated by using different accounting rules. As a thumb rule, a lower P/S ratio compared to the other companies in the same industry means that the stock is comparatively undervalued.

A few other popular financial tools that you can use to perform relative valuation of stocks are PEG Ratio (Price to Earnings to Growth Ratio), Price to Free Cash Flow etc.

How to do the Relative Valuation of Stocks?

For estimating the relative value of stocks, you need to set a benchmark. The companies that you are comparing should be from the same industry and it’s even better if they have a similar size (market capitalization). For example, a large-cap stock in the pharma industry should be compared with other large-cap companies in the pharma industry only.

Let’s assume that there are 5 companies in an industry and the average price-to-earnings ratio of the industry (i.e. Industry PE) turns out to be 20. Now, if the PE Ratio of the company that you are researching is 15, then it can be estimated to be relatively cheaper compared to the other stocks in the same industry.

Anyways, you have to use multiple financial ratios to find the relative value of the stocks, and should not rely on just one financial tool. If all the valuation ratios are indicating that one stock is comparatively cheaper, then it is a strong signal of an undervalued stock.

Limitations of Relative Valuations

No valuation technique can be perfect. There are few limitations of relative valuations that are discussed below:

1. The relative valuation approach does not give an exact value to enter stock (unlike discounted cash flow) as this approach is based on the comparison.
2. It is assumed that the market has valued the companies correctly. If all the companies in the Industry are overvalued, then the relative valuation approach might give a misleading result for the company in which you are interested.

How to find the Relative Multiples for Comparing Indian stocks?

You can use Trade Brains Portal to find the financial ratios of Indian stocks. Trade Brains Portal is a popular stock research website in India. While researching a company, you can get its 5-year financial data and ratios on Trade Brains Portal.

Moreover, one key tool available on Trade Brains Portal to perform the relative valuation of stocks in Stock Compare. Here, you can compare the financials of up to five stocks, all in one place. Just go on ‘Trade Brains Portal’ on the top menu bar, select the ‘Compare Stocks’ feature under ‘Products’. Enter the name of the companies and you’ll get the comparisons.

Trade Brains Portal is a powerful website for stock research. Just play around and get familiar with the website.

Conclusion

Relative valuation of stocks is a good alternative to absolute valuation. You can use this approach for a simple yet effective stock valuation. But do remember that comparing should be done for the stocks within the same industry and having a similar size (market capitalization). That’s all for this post on the Relative valuation of stocks. I hope it is useful for you.