Here's How Relative Valuation Can Be a Trap

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By 
BEN MCCLURE
 
 
Updated Mar 23, 2021
Relative valuation is a simple way to unearth low-priced companies with strong
fundamentals. As such, investors use comparative multiples like the price-
earnings ratio (P/E), enterprise multiple (EV/EBITDA) and price-to-book ratio
(P/B) all the time to assess the relative worth and performance of companies, as
well as identify buy and sell opportunities. The trouble is that while relative
valuation is quick and easy to use, it can be a trap for investors.

What Is Relative Valuation?

The concept behind relative valuation is simple and easy to understand: the
value of a company is determined in relation to how similar companies are priced
in the market.

Here is how to do a relative valuation on a publicly-listed company:

 Create a list of comparable companies, often industry peers, and obtain

their market values.
 Convert these market values into comparable trading multiples, such as
P/E, P/B, enterprise-value-to-sales, and EV/EBITDA multiples.
 Compare the company's multiples with those of its peers to assess
whether the firm is over or undervalued.

No wonder relative valuation is so widespread. Key data — including

industry metrics and multiples — is readily available from investor services like
Reuters and Bloomberg. In addition, the calculations can be performed with
fewer assumptions and less effort than fancy valuation models like discounted
cash flow analysis (DCF).

Watch out for the Relative Valuation Trap

Relative valuation is quick and easy, perhaps. But since it's based on nothing
more than casual observations of multiples, it can easily go awry.
Consider a well-known company that surprises the market with exceedingly
strong earnings. Its share price deservedly takes a big leap. In fact, the firm's
valuation goes up so much that its shares are soon trading at P/E multiples
dramatically higher than those of other industry players. Soon investors ask
themselves whether the multiples of other industry players look cheap against
those of the first company. After all, these firms are in the same industry, aren't
they?

If the first company is now selling for so many times more than its earnings, then
other companies should trade at comparable levels too, right? Not necessarily.
Companies can trade on multiples lower than those of their peers for all kinds of
reasons. Sure, sometimes it's because the market has yet to spot the company's
true value, which means the firm represents a buying opportunity. Other times,
however, investors are better off staying away. How often does an investor
identify a company that seems really cheap only to discover that the company
and its business are teetering on the verge of collapse?

Back in 1998, when Kmart's share price was downtrodden, it became a favorite
of some investors. They couldn't help but think how downright cheap the shares
of the retail giant looked against those of higher-valued peers Walmart and
Target. Those Kmart investors failed to see that the business's model was
fundamentally flawed. The company's earnings continued to fall and they
were overburdened with debt, leading Kmart to file for bankruptcy in 2002.1

Investors need to be cautious with stocks that are proclaimed to be

"inexpensive." More often than not, the argument for buying a supposedly
undervalued stock isn't that the company has a strong balance sheet, excellent
products or a competitive advantage. Trouble is, the company might look
undervalued because it's trading in an overvalued sector. Or, like Kmart, the
company might have intrinsic shortcomings that justify a lower multiple.

Multiples are based on the possibility that the market may presently be making a
comparative analysis error, whether overvaluation or undervaluation. A relative
value trap is a company that looks like a bargain compared to its peers, but it's
not. Investors can get so caught up on multiples that they fail to spot fundamental
problems with the balance sheet, historical valuations, and most importantly,
the business plan.

Do Your Homework to Avoid the Traps

The key to keeping free from relative value traps is extra homework. The
challenge for investors is to spot the difference between companies and figure
out whether a company deserves a higher or lower multiple than its peers.
For starters, investors should be extra careful when picking comparable
companies. It is not enough to simply pick companies in the same industry or
business. Investors need to also identify companies that have similar
underlying fundamentals.

Aswath Damodaran, author of The Dark Side Of Valuation (2001), argues that

any fundamental differences between comparable firms that might affect the
firms' multiples need to be thoroughly analyzed in relative valuation. All
companies, even those in the same industry, contain unique variables—such as
growth, risk, and cash flow patterns—that determine the multiple. Kmart
investors, for instance, would have benefited from examining how fundamentals
like earnings growth and bankruptcy risk translated into trading-multiple
discounts.

Next, investors will do well to examine how the multiple is formulated. It is

imperative that the multiple be defined consistently across the firms being
compared. Remember, even well-known multiples can vary in their meaning and
use.

For example, let's say a company looks expensive relative to peers based on the
well-used P/E multiple. The numerator (share price) is loosely defined. While the
current share price is typically used in the numerator, there are investors and
analysts who use the average price over the previous year.

There are also plenty of variants on the denominator. Earnings can be those from
the most recent annual statement, the last reported quarter, or forecasted
earnings for the next year. Earnings can be calculated with shares outstanding,
or it can be fully diluted. It can also include or exclude extraordinary items. We've
seen in the past that reported earnings leave companies with plenty of room
for creative accounting and manipulation. Investors must discern on a company-
by-company basis what the multiple means.

The Bottom Line

Investors need all the tools they can get their hands on to come up with
reasonable assessments of company value. Full of traps and pitfalls, relative
valuation needs to be used in conjunction with other tools like DCF for a more
accurate gauge of how much a firm's shares are really worth.