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.

What's the difference between absolute P/E ratio and relative P/E ratio?

What's the difference between absolute P/E ratio and relative P/E ratio?

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The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock divided by the company's earnings per share (EPS). This measure indicates how much investors are willing to pay per dollar of earnings. The relative P/E ratio, on the other hand, is a measure that compares the current P/E ratio to the past P/E ratios of the company or to the current P/E ratio of a benchmark. Let's look at both absolute and relative P/E in more detail.

Absolute P/E

The nominator of this ratio is usually the current stock price, and the denominator may be

• the trailing EPS (from the trailing 12 months [TTM]),
• the estimated EPS for the next 12 months (forward P/E) or
• a mix of the trailing EPS of the last two quarters and
• the forward projected EPS for the next two quarters.

When distinguishing absolute P/E from relative P/E, it is important to remember that absolute P/E represents the P/E of the current time period.

For example, if the price of the stock today is $100, and the TTM earnings are $2 per share, the P/E is 50 ($100/$2).

Relative P/E

Relative P/E compares the current absolute P/E to

• a benchmark or
• a range of past P/Es over a relevant time period, such as the last 10 years.

Relative P/E shows what portion or percentage of the past P/Es the current P/E has reached.

• Relative P/E usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low.
• The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low).
• If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.

Suppose a company's P/Es over the last 10 years have ranged between 15 and 40.

• If the current P/E ratio is 25, the relative P/E comparing the current P/E to the highest value of this past range is 0.625 (25/40), and the current P/E relative to the low end of the range is 1.67 (25/15).
• These value tell investors that the company's P/E is currently 62.5% of the 10-year high, and 67% higher than the 10-year low.

If all is equal over the time period, the closer the P/E gets to the high side of the range and further away from the low side, the more caution an investor needs since this could mean the stock is overvalued.

• There is, however, a lot of discretion that goes into interpreting relative P/E.
• Fundamental shifts in the company such as an acquisition of a highly profitable entity can justifiably increase the P/E above the historic high.

As we mentioned above, relative P/E may also compare the current P/E to the average P/E of a benchmark such as the S&P 500.

• Continuing with the example above where we have a current P/E ratio of 25, suppose the P/E of the market is 20.
• The relative P/E of the company to the index is therefore 1.25 (25/20).
• This shows investors that the company has a higher P/E relative to the index, indicating that the company's earnings are more expensive than that of the index.
• A higher P/E, however, does not mean it is a bad investment. On the contrary, it may mean the company's earnings are growing faster than those represented by the index.
• If, however, there is a large discrepancy between the P/E of the company and the P/E of the index, investors may want to do additional research into the discrepancy.

Conclusion
Absolute P/E, compared to relative P/E, is the most-often used measure and is useful in investment decision making; however, it is often wise to expand the application of that measure with the relative P/E measure to gain further information.

http://www.investopedia.com/ask/answers/05/051005.asp

Relative PE Ratios and Market Growth

Relative PE Ratios and Market Growth

As the expected growth rate on the market increases, the divergence in PE ratios increases, resulting in a bigger range for relative PE ratios.

This can be illustrated very simply, if you consider the relative PE for a company that grows at half the rate as the market.

When the market growth rate is 4%, this firm will trade at a PE that is roughly 80% of the market PE. When the market growth rate increases to 10%, the firm will trade at a PE that is 60% of the market PE.

This has consequences for analysts who use relative PE ratios. Stocks of firms whose earnings grow at a rate much lower than the market growth rate, will often look cheap on a relative PE basis when the market growth rate is high, and expensive when the market growth rate is low.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

Relative PE Ratios

 

Relative PE Ratios

 

Relative price earnings ratios measure a firm’s PE ratio relative to the market average. It is obtained by dividing a firm’s current PE ratio by the average for the market.

 

Relative PE = Current PE ratio (firm) / Current PE ratio (market)

 

Not surprisingly, the distribution of relative PE ratios mimics the distribution of the actual PE ratios, with one difference – the average relative PE ratio is one.

 

To analyze relative PE ratios, we will draw on the same model that we used to analyze the PE ratio for a firm in high growth, but we will use a similar model to estimate the PE ratio for the market. Brought together, we obtain the following.

Note that the relative PE ratio is a function of all of the variables that determine the PE ratio – the expected growth rate, the risk of the firm and the payout ratio – but stated in terms relative to the market. Thus, a firm’s relative PE ratio is a function of its relative growth rate in earnings per share (Growth Ratefirm/Growth Ratemarket), its relative cost of equity (Cost of Equityfirm/Cost of Equitymarket) and its relative return on equity (ROEfirm/ROEmarket). Firms with higher relative growth, lower relative costs of equity and higher relative returns on equity should trade at higher relative PE ratios.

There are two ways in which they are used in valuation.

• One is to compare a firm’s relative PE ratio to its historical norms; Ford, for instance, may be viewed as under valued because its relative PE ratio of 0.24 today is lower than the relative PE that it has historically traded at.
• The other is to compare relative PE ratios of firms in different markets; this allows comparisons when PE ratios in different markets vary significantly.

For instance, we could have divided the PE ratios for each telecom firm by the PE ratio for the market in which this firm trades locally to estimate relative PE ratios and compared those ratios.

Illustration:

Comparing Relative PE ratios for automobile stock – December 2000

In December 2000, the S&P 500 was trading at a multiple of 29.09 times earnings. At the same time, Ford, Chrysler and GM were trading at 7.05, 8.95 and 6.93 times earnings, respectively. Their relative PE ratios are reported.

Relative PE for Ford = 7.05 / 29.09 = 0.24

Relative PE for Chrysler = 8.95 / 29.09 = 0.30

Relative PE for GM = 6.93 / 29.09 = 0.24

Does this mean that GM and Ford are more under valued than Chrysler? Not necessarily, since there are differences in growth and risk across these firms. In fact, Figure 18.13 graphs the relative PE ratios of the three firms going back to the early 1990s. In 1993, GM traded at a significantly higher relative PE ratio than the other two firms. In fact, the conventional wisdom until that point in time was that GM was less risky than the other two firms because of its dominance of the auto market and should trade at a higher multiple of earnings. During the 1990s, the premium paid for GM largely disappeared and the three automobile firms traded at roughly the same relative PE ratios.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf