Relative Valuation: Comparing Stocks Using Price Multiples

Introduction

Relative valuation is the practice of comparing a company's market price to similar companies using simple ratios, usually called price multiples. It helps you judge whether a stock looks expensive or cheap relative to peers, without building a full financial model.

Why does this matter to you as a new investor? Because multiples give a fast, standardized way to compare businesses that operate in the same industry, and they highlight valuation differences that might merit deeper research. What will you learn here? You'll get clear definitions of the most used multiples, guidance on selecting peers, a step-by-step comparison process with examples, and the key limitations to watch for.

• Price multiples let you compare companies quickly, but they only tell part of the story.
• P/E, P/S, and EV/EBITDA each work best in specific business contexts.
• Choosing the right peers is as important as choosing the right multiple.
• Adjust for growth, margins, and capital structure when comparing multiples.
• Use multiples as a screening and sanity check tool, not a final decision maker.

What is Relative Valuation and Why It Matters

Relative valuation compares a company's valuation metric to those of similar companies. Instead of estimating intrinsic value from cash flows, you ask how the market values comparable firms. This approach is common among analysts and fund managers because it is fast and grounded in market prices.

Relative valuation matters because markets price similar economics in similar ways, most of the time. If two companies have similar growth, profitability and risk, a large gap in multiples suggests a gap in expectations or a mispricing. That can point you toward further research.

Common Price Multiples and How to Use Them

Different multiples emphasize different parts of a business. Here are the most common ones and when to use them.

P/E Ratio (Price-to-Earnings)

The P/E ratio divides market price by earnings per share. It measures how much investors pay for a dollar of reported earnings. P/E is most useful for profitable, mature companies with stable earnings, like large consumer names or utilities.

Limitations include sensitivity to accounting rules and one-time items. For example, $AAPL and $MSFT might have similar P/Es if both are mature tech firms, but a nonrecurring gain in one company could distort its reported earnings and make the P/E look artificially low.

P/S Ratio (Price-to-Sales)

Price-to-sales divides market capitalization by revenue. It is helpful for early-stage companies, loss-making firms, or cyclical businesses where earnings swing widely. Using P/S lets you compare companies that don't yet have reliable profits.

Remember to adjust for margins. A company with 5% net margin and a P/S of 2 is not the same as one with 20% margin and the same P/S. Always consider profit conversion from sales to earnings.

EV/EBITDA (Enterprise Value to EBITDA)

EV/EBITDA compares enterprise value, which includes debt and cash adjustments, to operating earnings before interest, taxes, depreciation and amortization. This metric is good for capital-intensive industries, because it removes the noise of different capital structures and depreciation methods.

EV/EBITDA is commonly used in industrials, telecom, and energy sectors. It is less useful for financial companies, where EBITDA is not meaningful, or for firms with large non-cash costs that matter for cash flow.

Other Multiples to Know

PEG ratio adjusts the P/E for expected growth, by dividing P/E by earnings growth rate. Price-to-book is useful for asset-heavy businesses such as banks and real estate. Free cash flow yield compares market value to free cash generated, and it focuses on cash that can actually be returned to shareholders.

Choosing a multiple depends on the company's business model. Ask yourself, what drives value in this industry, earnings or sales or cash flow? That question guides your choice.

Choosing Peers and Industry Context

Peer selection is the single most important skill in relative valuation. If you compare a high-growth software company to legacy hardware firms, your multiples will be misleading. Good peer groups are similar in business model, growth profile, geographic exposure and capital intensity.

Steps to pick peers:

1. Start with the same industry classification, like software or consumer staples.
2. Filter by business model, for example subscription versus transaction-based revenue.
3. Match on scale and geography where possible, because regional markets can have different growth and margins.

How many peers should you use? There is no single right number, but a group of 5 to 15 comparable companies usually gives a useful range. Too few peers and you risk idiosyncratic noise. Too many and you risk mixing in dissimilar businesses.

Real-world peer selection example

Suppose you're comparing a large e-commerce company like $AMZN to peers. Good peers include $BABA in cross-border e-commerce and large retail platforms. It would be less helpful to compare $AMZN directly to a brick-and-mortar retailer with a very different cost structure.

Applying Multiples: Step-by-Step Comparison

Here is a practical workflow you can use when comparing companies with multiples.

1. Select the right multiple for the business model, for example EV/EBITDA for capital-heavy firms.
2. Collect current market values and financial metrics, like earnings, sales and EBITDA for the last 12 months or next 12 months estimates.
3. Calculate multiples and look at the peer distribution, noting the minimum, median and maximum.
4. Explain why any company sits above or below the median using growth, margins, or risk differences.

Let's walk through a simplified numeric example using fictional but realistic numbers. Imagine three consumer electronics firms in the same region, Company A, B and C.

Company A: Market cap $50 billion, net income $2.0 billion, P/E = 25. Company B: Market cap $40 billion, net income $2.0 billion, P/E = 20. Company C: Market cap $30 billion, net income $1.5 billion, P/E = 20. Median P/E is 20 to 25. If Company A trades at P/E 25 while peers trade at 20, you ask why. Maybe Company A has higher growth, stronger margins, or lower risk.

Always adjust for growth. If Company A is expected to grow earnings 15% annually while peers grow 5%, a higher P/E may be justified. You can use PEG to factor that in, dividing P/E by growth rate. In our example Company A's PEG is roughly 25 divided by 15, about 1.7, while a peer at P/E 20 with 5% growth has PEG of 4, suggesting Company A is cheaper on a growth-adjusted basis.

Using EV/EBITDA to compare capital structure

Suppose two telecom operators, $TEL1 and $TEL2, have similar EBITDA but different debt levels. One has high debt, which lowers its equity value. If you only looked at P/E you might miss that. EV/EBITDA captures the whole capital structure. If $TEL1's EV/EBITDA is 6 and $TEL2's is 10, $TEL1 looks cheaper on an enterprise basis, but you must check for hidden risks like lower margins or regulatory issues.

Limitations of Multiples and When to Use Other Tools

Multiples are powerful, but they have important limits. They assume that accounting numbers are comparable across companies. That's not always true, because earnings can be affected by one-time items, different depreciation schedules, and tax rates.

Multiples also assume that past performance or near-term analyst estimates are a reliable guide to the future. In fast-changing industries, like some tech segments, earnings can swing and estimates can be wrong.

When to supplement multiples

Use discounted cash flow analysis if you need to understand long-term cash generation and reinvestment needs. Use scenario analysis when business outcomes are highly uncertain. And always read the company's financial notes, they often explain items that distort multiples.

Common Mistakes to Avoid

• Comparing dissimilar companies, which produces misleading conclusions. Avoid this by narrowing peers to similar business models and regions.
• Relying on a single multiple. Use multiple ratios and explain divergences by growth, margins, or risk.
• Ignoring accounting differences or one-time items. Adjust earnings or use pro-forma figures where appropriate.
• Forgetting to adjust for capital structure. Use EV-based multiples like EV/EBITDA when debt levels vary across peers.
• Treating market median as a stamp of approval. The market can be wrong or driven by sentiment, so use multiples as a screen, not a verdict.

FAQ

Q: What multiple should I use for a start-up with no profits?

A: For loss-making or early-stage companies use price-to-sales or measures focused on user metrics, like price-per-user. Also consider growth rates and free cash flow prospects rather than trailing earnings.

Q: How do I adjust for different accounting treatments across companies?

A: Look for one-time items in income statements, adjust earnings to be comparable, or use cash-based measures like free cash flow or EV/EBITDA which reduce accounting noise.

Q: Are higher multiples always bad?

A: No. Higher multiples often reflect higher expected growth or lower risk. You should analyze whether the premium is supported by stronger fundamentals like forecasted revenue growth or superior margins.

Q: Can I use relative valuation to value companies in different countries?

A: You can, but be careful. Different markets have different growth prospects, accounting standards, and risk premia. If you compare across countries, adjust for currency, growth expectations, and sovereign risk.

Bottom Line

Relative valuation using multiples is a practical, beginner-friendly way to compare companies. It helps you quickly identify valuation gaps and prioritize deeper research. When you use P/E, P/S, EV/EBITDA and similar ratios, always pick the multiple that fits the business model and build a sensible peer group.

Take action by practicing on a few companies you follow. Build a peer list, calculate several multiples, and ask why a company sits above or below the peer median. At the end of the day, multiples are a starting point that should trigger questions, not close the case.