Reading: The Challenges of Relative Valuation

The first key challenge is the choice of comparable firms. Because relative valuation solely depends on the valuation of the comparable firms, we should make sure that these firms are really comparable! 

In principle, what we are looking for is a firm that is identical in each and every dimension and for which we observe a valuation. Clearly, this is a condition we will hardly ever be able to meet in reality. There is usually no such thing as THE perfect comparable firm, and every firm has its individual characteristics. Therefore, analysts typically try to come up with a group of firms that are "similar" with respect to some key characteristics. This is the so-called Peer Group. By using a group rather than one single comparable firm, chances are that some of the comparables' individual characteristics cancel out so that we obtain a more representative picture of the valuation of a typical similar firm.

 

The key characteristics that financial analysts use when searching for comparable firms are:

• Industry (as a measure of comparability of business model)
• Size (in terms of sales, capitalization, number of employees)
• Listing status (as a measure of liquidity)
• Expected growth
• Margins (as a measure of competition and management quality)
• Geographic location
• Payout policy
• Capital structure
• Life-cycle stage
• etc.

 

Keep in mind that, in oder to conduct relative valuation, the firms we pick do not only need to be comparable, but we also need to be able to obtain valuations for these firms. As we discuss later in this chapter, this often limits the sample of "comparables" to firms that are listed on a stock exchange. 

It turns out that there are actually relatively few firms listed on a stock exchange. In the U.S., for example, out of the roughly 22 million businesses that exist, less than 4'000 are listed on a stock exchange. This is only 1 out of 5'500 firms! 

This limited choice implies that we are facing a trade-off: The larger the number of screening criteria we use from the list above, the smaller will be the resulting group of comparable firms. There is no general solution to this trade-off. The practical recommendation is to proceed as follows:

• In a first step, look for firms that operate in the same industry.
• Screen the resulting firms for "outliers." Are there firms on the list that are strikingly different from the others? These could be firms that are much larger, firms that currently go through a bankruptcy restructuring, firms that operate in significantly different market segments, or firms that benefit from a unique market position (superior patent protection, government ownership, etc.). If there are good reasons to believe that a firm is an "outlier," it might make sense to drop it from the list of potential comparable firms (and to remember why you dropped it).
• For the resulting peer group, compute the relevant valuation multiples (more on this in the next section). 
• Use the average or median valuation multiple of the peer group to estimate the value of your firm or its equity.

 

Example

There are several websites that provide information about the possible peer group for (listed) firms. In the following example, we use data from the website of Morningstar, an investment research company in the U.S. Suppose we want to value the Ford Motor Company using the P/E-Ratio as of December 2016. According to Morningstar, the following 14 firms constitute the peer group of Ford:

 

 

This table provides a nice illustration of the trade-offs that we have discussed above. For example, only two of the 14 companies are located in the U.S. Therefore, if we believe that geographic location is a key factor, the above list would shrink down to only two comparables: General Motors and Tesla. In this particular valuation situation, such a geographic focus might not make too much sense. After all, the car industry is heavily globalized. 

For simplicity, let us assume that the above list provides a representative picture of Ford's peers. The three columns to the right of the table provide the necessary financial information about the peer groups to conduct relative valuation: The market value of the firms' equity (in millions of USD), the firms' last net income (in millions of USD), and the P/E-Ratio that results when we divide the market value of equity by net income. For example, in the case of Audi AG, the equity value is 28'124 million and the net income was 3'701 million, for a P/E-Ratio of 28'124/3'701 = 7.6.

Note that two firms had a negative net income in the preceeding business year (Porsche and Tesla). For these firms, we cannot compute a reasonable P/E-ratio, as a negative P/E-ratio would indicate that a firm becomes increasingly valuable the more money it loses. Therefore, these two firms are excluded from any analyses that involve the P/E-Ratio. We will come back to this issue and the potential resulting bias in the next section.

The two rows at the bottom of the table show average and median P/E-Ratios for the remaining 12 firms. In our particular case, the average P/E-Ratio is 27.4 and the median P/E-Ratio is 9.0. 

In principle, we can now use these multiples to value the Equity of Ford. According to the financial statements, Ford's last net income was USD 7'247 million. Consequently, the estimated equity value based on the average and median P/E-Ratio is:

 

 

Depending on which ratio we use, the estimated equity value is either 65 billion (median) or almost 200 billion (average). Clearly, this does not look like a very meaningful valuation so far. What is going on?

 

Average vs. Median Ratios

A quick look at the table above reveals that there is one firm with a rather "extreme" value: Volkswagen with a P/E-Ratio of 222.5. Presumably, the scandal surrounding Volkswagen's software manipulation has left its mark on the firm's accounting profitability and led to a net income which is exceptionally low compared to previous years. This is a major challenge for most valuation multiples. More generally speaking, if the underlying financials are severely affected by extraordinary events, the resulting valuation multiples will generally not be meaningful.

Such outliers can pose a problem for valuations that base on average multiples from comparable firms. Since the average, or arithmetic mean, is computed by adding all values together and then dividing the resulting sum by the number of values, one extreme value can substantially change the average value. We can see this easily in the above table: If we take out the “abnormal” P/E-Ratio of Volkswagen, the resulting group average drops from 27.4 to 9.6!

Because the average value is rather sensitive to extreme values, the practical recommendation is to work with median values instead. The median reflects the “typical” ratio, in the sense that when we sort all values, the median will be right in the middle. Half of the observations are smaller than the median, the other half is larger. By how much these observations are smaller or larger does not affect the median.

As an illustration, suppose Volkswagen’s P/E-ratio is 2’000 instead of 223. Such an extreme value would boost the peer group’s average P/E-ratio to 176 but leave the median at 9.0.

Consequently, if we believe that there could be outliers in the available ratios, we should always work with the median multiple rather than the average multiple.

For our example, this means that, based on the median P/E-Ratio of the comparable firms, the estimated equity value of Ford Motors is approximately 65 billion. As a comparison, the actual market capitalization of Ford was approximately 50 billion.