In continuation with the explanation of the Discounted Cash Flow (DCF) method and its calculation from the last section. Discounted Cash Flow (DCF) Valuation is an absolute value model that aims to determine the intrinsic value of a stock on the basis of the present value of the company's expected future cash flows. While it is a fundamentally sound technique to value a stock, it falls short on the parameter of practical relevance. Stock market prices are very often driven by macroeconomic factors and market sentiments rather than just the company fundamentals. These factors that affect the entire industry and stock market are not taken into account in DCF Valuation. This is where Relative Valuation comes into picture.
Relative Valuation, specifically Comparable Company Analysis is a business valuation method that compares a company's value to that of its peers in the industry in order to assess its financial worth. In times of stock market crash or rally, the prices of a stock are completely disjoint from their fundamentally derived intrinsic value. Even in such cases, relative valuation gives us a method to compare a stock of a particular industry to its competitors and determine if it is a good buy or not. Some commonly used ratios are Price to Earnings (P/E), Price to Book Value (P/BV), Price to Sales (P/S). Out of these three ratios, it is not advisable to use the ratio P/S as the comparison between Price and Sales is incorrect. This is because the market price of a stock captures the equity or shareholder part of wealth of the firm whereas, Sales captures both the equity and debt component of the stock. A ratio should be consistent for it to be accurate and reliable.
An important prerequisite for carrying out relative valuation is that the companies being compared should not only belong to the same industry but also have similar underlying business model. Just like it's not possible to compare apples to oranges, companies whose business models are different cannot be compared. For example, comparing SBI cards to ICICI Bank would not be an appropriate comparison even though both companies are financial services companies. SBI Cards is a pure play credit card company while ICICI Bank is bank making their business models completely different. Comparing ICICI Bank to a company like HDFC is an appropriate comparison.
Another type of relative valuation method is Precedent Transaction Analysis where, historical transactions determine the current value of a company. Most commonly, these transactions fall under the category of Mergers and Acquisitions as it shows what another investor was willing to pay for the entire company. Certain ratios may also be used such as EV/EBITDA.