Relative valuation is a simple way to unearth low-priced companies with strong fundamentals. As such, investors use comparative multiples like the price-earnings ratio (P/E), enterprise multiple (EV/EBITDA) and price-to-book ratio all the time to assess the relative worth and performance of companies, and to identify buy and sell opportunities. The trouble is that while relative valuation is quick and easy to use, it can be a trap for investors.

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Quick and Easy

The concept behind relative valuation is simple and easy to understand: the value of a company is determined in relation to how similar companies are priced in the market. Here is how to do a relative valuation on a publicly listed company:

    * Create a list of comparable companies, often industry peers, and obtain their market values.

    * Convert these market values into comparable trading multiples, such as P/E, price-to-book, enterprise-value-to-sales and EV/EBITDA multiples.

    * Compare the company's multiples with those of its peers to assess whether the firm is over or undervalued.

No wonder relative valuation is so widespread. Key data - including industry metrics and multiples - is readily available. In addition, the calculations can be performed with fewer assumptions and less effort than fancy valuation models like discounted cash flow analysis (DCF).

Relative Valuation Trap

Relative valuation is quick and easy, perhaps. But because it's based on nothing more than casual observations of multiples, it can easily go awry.

Consider this: a well-known company surprises the market with exceedingly strong earnings. Its share price deservedly takes a big leap. In fact, the firm's valuation goes up so much that its shares are soon trading at P/E multiples dramatically higher than those of other industry players. Soon investors ask themselves whether the multiples of other industry players look cheap against those of the first company. After all, these firms are in the same industry, aren't they? If the first company is now selling for so many times more than its earnings, then other companies should trade at comparable levels, right?

Not necessarily. Companies can trade on multiples lower than those of their peers for all kinds of reasons. Sure, sometimes it's because the market has yet to spot the company's true value, which means the firm represents a buying opportunity. Other times, however, investors are better off staying away. How often does an investor identify a company that seems really cheap, only to discover that the company and its business are teetering on the verge of collapse?

Investors need to be cautious of stocks that are proclaimed to be "inexpensive". More often than not, the argument for buying a supposed undervalued stock isn't that the company has a strong balance sheet, excellent products or a competitive advantage. Trouble is, the company might look undervalued because it's trading in an overvalued sector. Or the company might have intrinsic shortcomings that justify a lower multiple.

Multiples are based on the possibility that the market may presently be making a comparative analysis error, whether overvaluation or undervaluation. A relative value trap is a company that looks like a bargain compared to its peers, but is not. Investors can get so caught up on multiples that they fail to spot fundamental problems with the balance sheet, historical valuations and most importantly, the business plan.

Do Your Homework

The key to keeping free from relative value traps is extra homework. The challenge for investors is to spot the difference between companies and figure out whether a company deserves a higher or lower multiple than its peers.

For starters, investors should be extra careful when picking comparable companies. It is not enough simply to pick companies in the same industry or businesses. Investors need also to identify companies that have similar underlying fundamentals.

Aswath Damadoran, author of the "The Dark Side Of Valuation" (2001), argues that any fundamental differences between comparable firms that might affect the firms' multiples need to be thoroughly analysed in relative valuation. All companies, even those in the same industries, contain unique variables - such as growth, risk and cash flow patterns - that determine the multiple.

Next, investors will do well to examine how the multiple is formulated. It is imperative that the multiple be defined consistently across the firms being compared. Remember, even well-known multiples can vary in their meaning and use.

For example, let's say a company looks expensive relative to peers based on the well used P/E multiple. The numerator - share price - is loosely defined. While the current share price is typically used in the numerator, there are investors and analysts who use the average price over the previous year. There are also plenty of variants on the denominator. Earnings can be those from the most recent annual statement, the last reported quarter, or forecasted earnings for the next year. Earnings can be calculated with shares outstanding, or it can be fully diluted, and it can also include or exclude extraordinary items. We've seen in the past that reported earnings leave companies with plenty of room for creative accounting and manipulation. Investors must discern on a company-by-company basis what the multiple means.

Investors need all the tools they can get their hands on to come up with reasonable assessments of company value. Full of traps and pitfalls, relative valuation needs to be used in conjunction with other tools like DCF for a more accurate gauge of how much a firm's shares are really worth.