The Little Book of Valuation, Updated Edition

Chapter FourIt's All Relative!: Determining Relative Value

IF CISCO (CSCO) IS TRADING AT 17 TIMES EARNINGS, Apple (AAPL) has a PE ratio of 21, and Microsoft (MSFT) is priced at 11 times earnings, which stock offers the best deal? Is Cisco cheaper than Apple? Is Microsoft a bargain compared to both Apple and Cisco? Are they even similar companies? Relative valuation is all about comparing how the market prices different companies, with the intent of finding bargains.

In relative valuation, you price an asset based on how similar assets are priced in the market. A prospective house buyer decides how much to pay for a house by looking at the prices paid for similar houses in the neighborhood. In the same vein, a potential investor in Twitter's IPO (initial public offering) in 2013 could have estimated its value by looking at the market pricing of other social media companies. The three essential steps in relative valuation are:

1. Find comparable assets that are priced by the market;
2. Scale the market prices to a common variable to generate standardized prices that are comparable across assets; and
3. Adjust for differences across assets when comparing their standardized values. A newer house with more updated amenities should be priced higher than a similar-sized older house that needs renovation, and a higher growth company should trade at a higher price than a lower growth company ...