Valuing Stocks - Relative Valuation

There are two basic methods of valuing stocks:

• Relative valuation
• Absolute valuation or Intrinsic Valuation

The most frequently used method is relative valuation, which compares a stock's valuation with those of other stocks or with the company's own historical valuations.  

For example, if you were considering the relative valuation for a chemical company CC, you would compare its stock's price/earnings ratio (or its price/sales ratio, etc.) with that of other chemicals makers or with that of the overall stock market.  

• If CC has a P/E ratio of 16 and the average for the industry is closer to, say 25, CC's shares are cheap on a relative basis.  
• You can also compare CC's P/E with the average P/E of an index, such as the S&P 500,  to see whether CC still looked cheap.  

The problem with relative valuations is that not all companies are made alike - not even all chemicals makers.

There could be very good reasons why CC has a lower P/E than its average peer.  

• Maybe the company doesn't have the growth prospects of other chemicals companies.  
• Maybe the possible liability from a product litigation rightly puts a damper on the stock's price.  

After all, a Hyundai has a lower sticker price than a Mercedes, but for very good reasons.

The key is to research your stocks well and be aware of the factors that might justifiably make them cheaper or more expensive than similar stocks.