Question

Critique relative valuation as an equity valuation tool?

Answer 1

A relative valuation model measures an asset value in relation to another asset. The underlying principle of this concept is that similar assets should sell at similar prices and is commonly measured in price multiples. Metrics such as Enterprise value/ EBDITA , Enterprise value/Revenue among others. For instance, a stock that has a low P/E ratio in comparsion to a similar stock is often undervalued and is considered a good buy. The major advantages of a relative valuation model can be underlined as below:

1. This model requires lesser assumptions when compared to the discounted cash flows method.

2. It reflects market perceptions better than any other method i.e. how a security is currently being valued by the market and can be used as a comparison measure at different levels.

3. It can be used as a benchmark and judge performance of the asset.

The shortcomings of this model include:

1. A portfolio of stocks that have been undervalued by this model can be overvalued per other models which does not ensure consistency.

2. It has unrealistic assumptions that the market aggregates are correct although there can be errors in individual securities.

3. It does not consider other important variables such as growth ,risk and cash flows.