Encyclopedia of Financial Models II

Relative Valuation Methods for Equity Analysis

GLEN A. LARSEN Jr., PhD, CFA

Professor of Finance, Indiana University, Kelley School of Business–Indianapolis

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

CHRIS GOWLLAND, CFA*

Senior Quantitative Analyst, Delaware Investments

Abstract: Relative valuation methods use multiples or ratios, such as price/earnings, price/book, or price/free cash flow, to determine whether a particular firm is trading at higher or lower multiples than its peers. Such methods require the user to choose a suitable universe of firms that are more or less comparable, though this can become difficult for firms with unusual characteristics in terms of product mix or geographical exposure. Relative valuation methods can be useful for portfolio managers who expect to be fully invested at all times, as they provide a practical tool for attempting to capture the “value premium” by which firms trading at lower multiples tend to outperform those trading at higher multiples. Implicitly, relative valuation methods assume that the average multiple across the universe of firms can be treated as a reasonable approximation of “fair value” for those firms; this may be problematic during periods of market panic or euphoria.

Much research3 in corporate finance and similar academic disciplines is tilted toward the use of discounted cash flow (DCF) methods. However, many analysts also make use of relative valuation methods, which compare several ...