Definition of Comparable companies valuation
Comparable companies valuation use multiples estimating the value of a company by looking at the pricing of comparable assets relative to a common variable like earnings (P/E), book value (P/Book), sales (P/S) or cash flows. These models assume that the market, on average, prices companies correctly and that the company being valued is comparable to other companies.
1) P/E ratio
The most frequently applied multiples are P/E ratio, P/BV ratio and P/S ratio. The first, P/E ratios is a price-to-earnings ratio and employed generally to determine the appropriate stock price of a company. This multiples is the most widely used and known of all multiples since it is very simple to calculate for most companies and makes comparisons simple, something that saves time and provides a good proxy of the fair value of a company. But P/E ratio is limited to apply to companies only with positive earnings and furthermore, volatility of earnings results in changes in the P/E ratio from period to period, which makes the P/E ratio less reliable. The simple calculation can be written as:
P/E = P/EPS
where P = share price and EPS = earnings (net income after tax) per share
2) P/B ratio
The second, P/BV ratio is a price-to-book value (of equity) ratio and the book value of equity is the difference between the book value of total assets and the book value of liabilities. This multiple is employed to compare the value of a company to others’ in the simplest way since book values are stable and often possible to compare to market prices. Moreover the valuation of companies even with negative earnings which are troublesome for the P/E ratio as well as DCF valuation model is not as big of an obstacle with P/BV ratio. But book values depend on accounting standards and principles and thus, make it difficult to compare with companies in other countries.
3) P/S ratio
The third, P/S ratio is a price-to-sales (revenue) ratio. This multiple is employed generally to new companies that invest heavily in the beginning and earn negative cash flows for the early years. Since sales is hard to manipulate and is not influenced by accounting decisions, this multiple provides a relatively fair value of a company.
Trading comps valution
The main benefits of using a comparable companies valuation with multiples are that they are relatively simple to calculate and easy to understand. The other advantage is that it is based on the market price, which can be expressed as the market’s estimate of growth and risk for the specific type of business. However, relative valuation methods are easy to manipulate or misuse since relative valuation does not say anything about if a company is under- or overvalued, only how it relates to the current valuation of similar/ comparable companies. Performing several different valuations techniques, where relative valuation is one, multiples can give a fair valuation range. In addition, several different multiples exist on the market today and in order to get a clear picture of the price range several different multiples should be used when performing a business valuation.