Relative Valuation

 

It is a form of valuation process where an asset is valued by comparing it with the other ones in the market which are very similar to this one. It is also known as comparable valuation.

For example, in the real estate market, anytime a property is being valued, the most important things which are being taken into account are the values of the neighboring properties which have been sold in recent times, their size compared to the one undervaluation, their positioning in the area, etc.

 

Relative valuation is a great tool to use to measure the valuation of various stocks in the stock market and to find out whether they are overvalued or undervalue and be able to make various investment decisions.

 

This could be done using various metrics such as 

 

1. Price to earnings ratio(P/E Ratio)
   The p/e ratio is used as a company valuing ratio and is calculated by dividing the market value of the share by the earnings per share. In order to compare various firms’ share value in the same industry, their p/e ratio is compared to the overall industry average and if the p/e ratio of the firm is higher than that of the industry, then the value of the share is considered to be overvalued and a conclusion can be drawn that the price will decline in the long run to match with the overall industry. Vice-versa, if the p/e ratio is lower than that of the industry, the price of the share is said to be undervalued and it is said that the price will increase in the long run.
    

2. Return on Equity(ROE)
   Return on equity is said to be a tool to measure the financial performance of a firm as it measures the firm’s profitability with respect to the shareholder’s equity. It is calculated by dividing net income by the overall shareholder’s equity. Since the shareholder’s equity is the net of total assets minus the debt, return on equity is also known as return on net assets. The firm’s performance can be checked by comparing its roe with the overall industry’s performance, if the roe of the firm is less than that of the overall industry, it is said to be giving a poor performance and the value of the shares might drop in the future, vice-versa, if the roe of the firm is greater than the industry’s roe, it is giving high performance and the share value might rise in the future.

3. Dividend Paid
   The dividend paid by a firm to its shareholders can disclose a lot about the financial information about the firm as if we compare the dividends released by a firm to the industrial average in the set time range and they are less in comparison, it states that the firm might be having some financial troubles in the minds of investors and might lead to an overall reduction in the value of its stocks
    

4. Operating Margin
   It is a measure of how much a company earns in profit for one rupee of sale after paying all the variable costs per unit. It is calculated by dividing a company’s operating income by its net sales.