The Relativity of Value

Relative valuation involves estimating the value of an asset by comparing it to the market prices of similar assets, typically using valuation multiples like price-to-earnings (P/E), price-to-sales (P/S), or EV/EBITDA ratios. The core appeal of relative valuation lies in its simplicity—it allows you to quickly gauge a company's value relative to its peers without diving into complex discounted cash flow models.

However, despite its simplicity, the success of relative valuation hinges on selecting the right comparable firms and making adjustments for differences in growth, risk, and cash flow profiles. This is where the challenges of relative valuation arise:

Key Considerations in Relative Valuation:

1. Finding Comparable Firms:

   • Industry and Size: The chosen firms should ideally operate in the same industry and be of similar size.

   • Growth Prospects: If one firm is growing much faster than the others, it might command a higher multiple, which should be adjusted for.

   • Geography: Regional or country-specific factors, like different regulations or market conditions, can impact comparability.

2. Adjusting for Differences: Even firms within the same sector can have significant differences in growth, risk, and cash flow generation. These need to be accounted for to arrive at a fair comparison:

   • Growth: A firm with stronger growth potential might deserve a higher multiple. Adjusting for growth is critical to ensure that comparisons are accurate.

   • Risk: Companies with different risk profiles (e.g., debt levels, volatility, or business model risk) will have different valuations. Higher-risk companies might trade at a discount relative to safer firms.

   • Cash Flows: Differences in profitability and cash flow generation also impact valuation. Firms with strong, predictable cash flows often command higher valuations than those with uncertain or negative cash flows.

Challenges in Applying Relative Valuation

In modern markets, finding truly comparable firms and making precise adjustments can be quite difficult due to several factors:

• Complex Business Models: Companies often diversify their operations, making it harder to find pure-play competitors.

• Market Sentiment and Bubbles: Certain sectors (e.g., tech in the 2000 dot-com bubble or cryptocurrencies) may see inflated prices driven by hype rather than fundamentals, skewing relative comparisons.

• Globalization: With firms operating across different geographies, economic environments, and regulatory regimes, finding perfect peers becomes increasingly complex.

The Relativity of Value

Just as in physics, where observations are dependent on the observer's frame of reference, the value of a stock can change based on the companies or benchmarks chosen for comparison. In some cases, all the comparable firms might be mispriced by the market, as seen during speculative bubbles, leading to misleading conclusions.

For instance, during the dot-com bubble, internet stocks were frequently valued using relative valuation based on other overpriced internet companies, which skewed the perception of their "fair" value. If one firm was overpriced, it could justify high valuations for others, despite all being overvalued in absolute terms.

Conclusion

While relative valuation is simple and useful, it requires careful judgment in selecting comparables and adjusting for key differences. The method can mislead if not applied thoughtfully, especially in dynamic or speculative markets where finding true comparables and adjusting for growth, risk, and cash flows can be exceptionally challenging.