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# What is Relative Value?

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Relative valuation is a method of determining a stock’s value that takes into account how the market prices similar companies. Thus, when determining what to pay for a house, we look at what similar houses in the neighborhood sold for rather than doing an absolute valuation of everything the house has. Extending this analogy to stocks, investors often decide whether a stock is cheap or expensive by comparing its pricing to that of similar stocks.

## Valuation using multiples

Generally, “multiples” is a generic term for a class of different indicators that can be used to value a stock. A multiple is simply a ratio that is calculated by dividing the market value of an asset by a specific item on the financial statements.

The use of standardized financial metrics allow for comparisons of value among companies with different characteristics, most notably size. If we have to compare the prices of two buildings of different sizes in the same location, the smaller building will look cheaper unless we control for the size difference by computing the price per square foot.

To compare the values of “similar” firms in the market, we need to standardize the values in some way by scaling them to a common variable.

### Standard multiples

Prices can be standardized using a common variable such as earnings,
cashflows, book value or revenues.

We provide information on the following ratios:

• P/S. The Price to Sales ratio is a valuation multiple that compares a company’s market capitalization to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales.
• P/E. The Price to Earnings ratio is a valuation multiple that compares a company’s market capitalization to its net income. It indicates the dollar amount an investor can expect to invest in a company in order to receive \$1 of that company’s earnings.
• P/OCF. The Price to Operating Cash Flow ratio is a valuation multiple that measures the value of a company’s market capitalization relative to the operating cash flow it generates. Some analysts prefer P/OCF over P/E since earnings can be more easily manipulated than cash flows.
• P/FCFE. The Price to Free Cash Flow To Equity ratio is a valuation multiple that compares a company’s market capitalization to the amount of free cash flow available for equity shareholders. This metric is very similar to the P/OCF but is considered a more exact measure, owing to the fact that it uses free cash flow, which subtracts capital expenditures (CapEx) from a company’s operating cash flow.
• P/B. The Price to Book Value ratio is a valuation multiple that measures the market’s valuation of a company relative to its book value. The P/B ratio is only considered useful in practice when applied to capital-intensive businesses.
• EV/S. The Enterprise Value to Sales ratio is a valuation multiple that compares the enterprise value (EV) of a company to its revenues. The EV/S multiple gives investors a quantifiable metric of how to value a company based on its sales while taking account of both the company’s equity and debt.
• EV/EBITDA. The Enterprise Value to EBITDA ratio is a valuation multiple that compares the value of a company, debt included, to the company’s cash earnings less non-cash expenses. EBITDA can be misleading at times, especially for companies that are highly capital intensive.
• EV/EBIT. The Enterprise Value to EBIT ratio is a valuation multiple that compares the value of a company, debt included, to the company’s earnings before interest and taxes (EBIT). Considered one of the most frequently used multiples for comparisons among companies, the EV/EBIT multiple relies on operating income as the core driver of valuation.
• EV/OCF. The Enterprise Value to Operating Cash Flow ratio is a valuation multiple that measures the value of a company, debt included, to the operating cash flow it generates.
• EV/FCFF. The Enterprise Value to Free Cash Flow To Firm ratio is a valuation multiple that compares the value of a company, debt included, to the amount of free cash flow available for all stakeholders. This metric is very similar to the EV/OCF but is considered a more exact measure, owing to the fact that it uses free cash flow, which subtracts capital expenditures (CapEx) from a company’s operating cash flow.
• EV/IC. The Enterprise Value to Invested Capital ratio is a valuation multiple that measures the dollars in Enterprise Value for each dollar of capital invested by shareholders and lenders.

### Forward-looking multiples

Forward multiple is a multiple version that uses forecasted variable for its calculation. For example, forward P/E is a version of the P/E ratio that uses forecasted earnings for its calculation.

### Multiples benchmarks

In order to understand whether the value of the multiple is high or low, you need to compare it with something. To do this, we provide information about the historical values of the multiple, as well as its industry value.

## How relative value calculated

Alpha Spread takes into account all the information about the company’s valuation multiples and consolidates it into one single number – relative value.

More specifically, our algorithm estimates target multiple for each valuation multiple, and calculates the stock value based on it. The average of these values is a relative value.

The quality of such a valuation depends on the quality of the calculation of the target multiple. When estimating the target multiple, our algorithm takes into account:

• Multiple’s historical values. It analyzes the historical distribution of multiple values to understand how a company has historically been valued.
• Growth prospects. A company with high expected growth should trade at a higher multiple than a company with lower expected growth. Our algorithm uses regression models to calculate the relationship between the multiple value and the expected growth.
• Industry multiple value. Our algorithm analyzes the multiple values of companies located in the same industry in order to increase the accuracy of the multiple target estimate.

## The bottom line

Relative valuation is used to value companies by comparing them to other businesses based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E ratios. Alpha Spread takes into account all the information about the company’s valuation multiples and consolidates it into one single number – relative value.

Updated on May 5, 2022