Relative Valuation and It’s Nuances
Introduction
Relative Valuation method is that approach to valuation that compares the value of the company with its competitors and industry peers to arrive at a valuation for the company. This is an alternate method that is used in place of “Absolute Value Models” which usually measure the value of a company by calculating the intrinsic value of the company using estimated cash flows and then discounting that value to its present value. Although these methods are industry standard when it comes to putting a value to company, but it does not consider how other similar companies/competitors are valued at. Relative Valuation helps us tackle this issue. This method of valuation is extremely useful start ups with almost no historical data to value their company on the basis of an absolute value model such as the Discounted Cash Flow Method.
Let’s discuss some of the approaches used under relative valuation method.
Relative Valuation method consists of two approaches:
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Trading Comparable Approach – This relative valuation approach focused on how similar publicly companies are traded in the open market and then derive a value using a valuation matrix, popularly known as Multiples. Trading Comparable method is one of the most commonly used valuation approach when it comes to using a Relative valuation method. Some of the most common multiples used for trading comparable valuation are Enterprise Value Multiples.
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Transaction Comparable Approach – This relative valuation approach focuses on how similar public companies are being bought or sold. We then use Multiples (similar to those mentioned above) to derive valuation for the company. Transaction comparable company analysis is usually not individually used to value a company. It is used more or less in combination with DCF valuation method, Trading Comparable method or both to arrive at a much more realistic and reliable valuation of the target company. This is because transaction data used this approach is highly sensitive and may or may not be readily available. To perform a reliable valuation, we need to have access to reliable database that contain accurate and reliable transaction information.
Important Factors in Relative Valuation
There are several factors that affect the valuation of a company when using relative valuation method. Some of the key nuances that we will be discussing in this blog are as follows:
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Comparability - The companies against which the valuation is to be estimated should be selected very carefully
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Accounting methods and financial reporting standards – Difference between the accounting standards as well as the financial reporting standard needs to be considered very carefully.
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Timing - The time at which the valuation is done also impacts the valuation outcome for the company.
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Macro-Economic Factors – Macro Economic factors such as market condition, inflation, geopolitical scenario, industry trend etc affect relative valuation outcome.
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Biases and Subjective Judgement – Relative valuation is very prone to biases and subjective judgement which an analyst must keep in mind while using relative valuation methods.
Let’s dive deeper into what these nuances actually comprise of and how we can make the most reliable assumptions and computations, when it comes to relative valuation.
Key Nuances to Relative valuation Approach
Comparability
Comparability of companies that are being used to access the valuation of the target company should be, if not exactly same, but similar to the target company. Some of the things to consider while choosing comparable companies for valuation using the relative valuation method are:
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Industry of Operation
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Market Capitalization
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Business model
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Geographical area of operations
The basis of relative valuation method majorly depends on the comparable companies/transactions selected to carry out the valuation. Thus, it becomes extremely important for us to understand the target company properly and choose the comparable companies, keeping them in line with the target company.
Accounting Method and Financial reporting standard
When shortlisting the comparable companies there may be a situation where similar companies cannot be located within the geographical confines of the target company. To overcome this, comparable companies outside the geographical are of operations of the target firm can be selected for the valuation.
When a situation like this arises, any difference in the accounting standards and financial reporting standards should be accounted for with respect to the target company in its valuation.
Timing of the valuation
Timing of valuation would play a key role in Relative valuation. Since the market conditions can be highly dynamic, the timing of the valuation for the target company and the investment transaction involved is very important. The transaction might happen at a later stage after the valuation is done which might show a significant change in valuation, thus, it becomes extremely important to consider the time factor when using relative valuation. A vigilant valuation update process throughout the transaction timeline can be built to overcome this.
Macro-Economic Factors
Macro-Economic factors such as the inflation, industry specific trend, geopolitical event such as elections, interest rates etc can impact the outcome of a relative valuation. When valuing a company using relative method of valuation these factors are to be adjusted for while calculating the value for the target company.
Even if we assume that these factors do not affect the target company, the public companies that we use as a benchmark to arrive at the valuation will certainly react to changes in these factors resulting in a change in valuation of the target company.
Biases and Subjective Judgement
Biases and Subjective Judgement is a challenge that is faced while using any of the several valuation methods. Valuation being a subjective process, the biases of the analyst, against or for, the target company or its comparable can create an inefficiency in the valuation of the company. This nuance is more or less analyst oriented and not only dependent on the company. The decision-making process while valuing a company using the relative valuation method should be constantly checked for biases and subjective judgement that would impact the valuation of the target company.
Concluding thoughts
Relative valuation method is commonly used with in sync with other standard valuation methods such as the DCF valuation method. Relative valuation methods do not require previous historical data of the target company to arrive at a valuation which makes it more attractive when valuing a startup or a company with limited data rendering the data less reliable to make cashflow projections. Thus, relative valuation method can be used to value companies with no or limited historical data.
In some cases, relative valuation can be used to provide a testing mechanism for the valuation derived from the DCF method of valuation. In addition to this, relative valuation method can be utilized to perform a football field analysis for the target company valuation to help achieve a more reliable valuation.
It is extremely important to have a good and solid set of base comparable companies when using relative valuation and even though it may not be the first method of choice for an analyst to value a company but it certainly is powerful tool to that can also be used for validation of valuation arrived at using other methods. Uses and application of Relative Valuation method may vary depending on the context it is being used, but the nuances in every case remains the same. Their effect may get magnified or minimized depending on the transaction involved.