What is relative valuation?

Relative valuation estimates a stock’s value by looking at how the market prices similar companies.

Think of buying a house. You look at what similar homes nearby have sold for, instead of pricing the bricks and the roof one by one. Investors judge stocks the same way: they compare a stock’s price with the prices of similar stocks.

Valuation multiples

A multiple divides a company’s market value by a financial metric, such as earnings or revenue. This puts companies of different sizes on the same scale, the way price per square foot lets you compare buildings of different sizes.

Multiples we use

Equity multiples compare the market capitalization with a financial metric:

• P/S, price to sales: market capitalization divided by revenue.
• P/E, price to earnings: market capitalization divided by net income.
• P/OCF, price to operating cash flow. Some analysts prefer it to P/E, because cash flow is harder to adjust with accounting choices than earnings.
• P/FCFE, price to free cash flow to equity: like P/OCF, but after capital expenditures.
• P/B, price to book value. Most useful for capital-intensive businesses.

Enterprise value multiples count debt as well as equity:

• EV/S, enterprise value to sales.
• EV/EBITDA, enterprise value to earnings before interest, taxes, depreciation and amortization. It can make capital-intensive companies look cheaper than they are.
• EV/EBIT, enterprise value to operating income. One of the most widely used multiples.
• EV/OCF, enterprise value to operating cash flow.
• EV/FCFF, enterprise value to free cash flow to the firm, after capital expenditures.
• EV/IC, enterprise value per dollar of capital invested by shareholders and lenders.

A forward multiple uses a forecast instead of a reported figure. Forward P/E, for example, divides the price by expected earnings.

Is a multiple high or low?

A multiple means little on its own. Alpha Spread shows each multiple next to its own history and the industry average, so you can see whether it is high or low.

How Alpha Spread calculates multiples-based value

Alpha Spread combines all of a company’s multiples into one number: the multiples-based value. For each multiple, the algorithm estimates a target value, converts it into a stock price and then combines these prices.

The target multiple takes into account:

• The multiple’s history: how the market has valued the company in the past.
• Growth prospects: a company expected to grow faster should trade at a higher multiple. Regression models measure this link.
• Industry multiples: how the market values other companies in the same industry.

The multiples-based value is one of the methods behind a stock’s intrinsic value.