Stock valuation is an essential aspect of investing. It involves estimating the worth of stocks based on projections of future cash flows and market sentiment analysis.

Absolute and Relative approaches are two main stock valuation methods – Absolute using fundamental analysis and financial information from businesses’ fundamentals while Relative using market standards as comparison points for stock prices.

What is a Relative Valuation?

Relative valuation refers to the practice of comparing the value of one asset or company with that of similar assets or companies in order to deduce their true worth. This form of evaluation rests on the assumption that markets accurately price assets; hence it can provide insight into determining an asset’s true value by studying similar offerings on the market.

This valuation technique can be helpful when assessing a prospective investment as it gives an indication of whether the company has been valued attractively or too highly. However, for best results it must be used alongside other methods of evaluation to obtain an accurate fair value estimation estimate.

Relative valuations can be performed using any number of metrics, including price/earnings ratios, price/book value ratios and enterprise multiples. Furthermore, precedent transaction analysis (examining takeover prices of businesses with similar characteristics in history) may also be utilized; unlike absolute valuation methods however, relative valuations use real world pricing data more easily and are usually more user friendly than absolute methods.

How to Value a Company Using a Relative Valuation Method

Stock valuation is the process of ascertaining a company’s true intrinsic value and is essential for investors looking to generate market-beating returns from their investments.

There are various valuation techniques, with absolute valuation techniques such as discounted cash flow (DCF) and dividend discount models providing estimates of an asset’s intrinsic value by analyzing projected future earnings and discounting them to present value using a required rate of return or discount rate.

Relative valuation models compare companies to their market counterparts by calculating multiples and ratios such as price-to-earnings multiples (P/Es). Since these methods can rely on assumptions for inputs into the model, their outputs may be more sensitive to small changes than others.

Relative valuation methods may also be much quicker and simpler to calculate than DCF calculations due to fewer assumptions required and their use of current market data, making them easier for individuals than complex projections with discount rates attached.

How to Create a Relative Valuation Model

Relative valuation models differ from intrinsic valuation methods like discounted cash flow (DCF) in that they use comparable assets or transactions to estimate an asset’s approximate worth. To do this, target assets’ prices are assessed against comparable transactions to ensure apples-to-apples comparisons are made between properties. This approach can be particularly helpful when valuing homes; it may even be applied when appraising publicly traded company stocks.

As with all valuation methodologies, relative valuation has its limitations. Primarily, it relies on the assumption that markets are accurately pricing a company’s stock – something which may not always be true during periods of market disruption or when entering new, untested markets.

Relative valuation metrics also fail to take account of a company’s growth potential, which can have significant ramifications on long-term returns. Therefore, relative valuation should serve only as one tool among many in evaluating a company’s value.

How to Apply a Relative Valuation Model

Relative valuation models help estimate the value of companies by comparing them with similar assets with similar risk/reward profiles and fundamental traits – such as comparable companies, peers or precedent transactions.

Relative valuation can provide analysts and investors looking for quick assessments of market dynamics a more effective tool than intrinsic valuation does, which requires deep knowledge of a company’s finances and projections. Relative valuation allows firms to tailor the valuation according to their specific characteristics – making it an efficient solution.

Relative valuation can be an inexact science that’s easily altered by macro economic trends or sentiment. Furthermore, its results can easily become over or under valued due to small variations in assumptions; such as when the model assumes interest rates are too low and will rise in the future – an assumption which could alter discounted cash flow calculations dramatically and lead to misguided investments decisions.