Relative Valuation

A relative valuation values a company not by estimating its intrinsic cash flows, but by seeing what the market pays for similar companies. If software companies trade at 25x EBITDA and your company has 50 million EBITDA, it is worth 1.25 billion. It is faster and more market-grounded than discounted cash flow, but it is also circular: it assumes the market is right.

Relative vs. intrinsic valuation

Intrinsic valuation (DCF) asks: what are all future cash flows worth? It is bottoms-up, based on company fundamentals.

Relative valuation asks: what are similar companies worth? It is market-based, not fundamental.

In intrinsic valuation, if the market misprice a company, your DCF would discover the mispricing, and you could profit.

In relative valuation, if the market misprices the peer set, you inherit that mispricing. If all software companies are overvalued, your relative-valuation conclusion will be overvalued too.

Methods of relative valuation

Trading multiples (comparable company analysis). Look at public peers. Calculate EV/EBITDA, PE, EV/Sales for each. Apply the median to your target.

Transaction multiples (comparable transactions). Look at M&A deals. What multiple was paid? Apply it to your target.

Peer averages with adjustments. Start with peer multiples. Adjust for growth, profitability, risk, size differences.

Advantages of relative valuation

Market-grounded. Reflects what actual buyers and sellers are currently paying, not a theoretical model.

Fast. Minutes to an hour, not weeks of DCF modeling.

Easy to communicate. “Your company trades at 10x while peers trade at 12x, so it’s undervalued” is intuitive.

Standard in M&A. Buyers, sellers, banks, and boards all speak multiples. Relative valuation is the lingua franca.

Less sensitive to discount rate. DCF is extremely sensitive to cost of equity and perpetual growth assumptions. Relative valuation is only sensitive to which multiple you choose.

Disadvantages of relative valuation

Assumes market is right. If the peer set is overvalued, you will be overvalued too.

Ignores company differences. If you apply a peer’s 12x multiple to a lower-growth company, you are overpaying for lower growth.

Doesn’t reveal value drivers. Why do peers trade at 12x? Because they grow at 10% and have 25% EBITDA margins. If your company grows at 5% with 20% margins, 12x might be too high. Relative valuation won’t tell you this.

Circular in bubbles. In 2000, internet stocks traded at 100x revenue. Using relative valuation would have suggested internet companies were worth these multiples. They were not.

Limited sample. Not all companies have close peers. A unique business has no clean comparables.

Making relative valuation more rigorous

Explicit adjustment for differences. Don’t just apply the median. Calculate multiples for each comparable, then adjust each for growth, profitability, risk:

Adjusted multiple = Peer multiple × (Target growth / Peer growth) × (Target margin / Peer margin) × …

This is more subjective but more honest than blind averaging.

Weight by similarity. Give more weight to comparables that are most similar to the target.

Reconcile to intrinsic value. Build a DCF for a few peers to understand what cash flows justify their multiples. Then apply that understanding to your target.

Test against transactions. If trading multiples suggest 12x and transaction comps show 10x, the difference might be normal market spread or might signal that trading prices are elevated.

The peer set must be truly similar

This is the biggest challenge. Comparables analysis is only as good as the peer group. A few questions to verify:

• Are they in the same industry? (Yes, but which sub-segment?)
• Are they similar size? (Size often correlates with profitability and growth rate.)
• Do they have similar growth rates? (Growth drives multiples.)
• Do they have similar profitability? (Margins drive value.)
• Do they have similar capital needs? (CapEx intensity affects cash available for distribution.)
• Do they face similar risks? (Regulatory, competitive, technology risk.)

If the answers are “somewhat” rather than “yes,” your peer group is imperfect, and multiples are less reliable.

Industry cycles and valuation multiples

Multiples compress and expand over time. A utility that normally trades at 12x EBITDA might trade at 14x in a low-rate environment and 10x in a high-rate environment. Using 14x for a long-term valuation might be wrong if rates are mean-revert

ing.

Some analyses show “normalized multiples” (what the company would trade at over a full cycle) rather than current multiples. This is more defensible for long-term value but requires judgment about what “normal” is.

See also