Ratios and Relative Value Analysis Technique for Valuing Firms for Beginners

Understanding ratios and relative value analysis technique for valuing firms for beginners
By John Williams, Business Writing and Research If you need to determine the value of firms within your industry, there are two fundamental value analysis techniques to choose from. Discounted flow valuation has you analyzing details and making a series of assumptions about the intrinsic worth of a firm, calculating the company’s worth based on how much money it projects to earn minus a discount for what that money will be worth in the future. The more commonly used relative valuation techniques determine the value of a company based on the value of similar companies.

The differences between using ratios and relative value analysis technique for valuing firms versus discounted cash flow can be both a strength and a weakness. It takes less time and resources to delve into, and it’s easier to sell or defend because it’s predicated on an “everybody’s doing it” argument, but the market determines a company's value because all other similar companies are worth that much. Before carrying out company comparisons, walk through three steps:

1. Determine whether relative valuation is right for you.

2. Develop a scale to standardize prices based on a common variable.

3. Adjust for differences between the assets under comparison using similar assets already priced in the market.

Decide whether to use ratio evaluations when comparing firms

While you can save considerable time and effort using the relative valuation technique, keep a close watch on market behavior. If the market has been either overly optimistic or pessimistic, it will over- or under-value all assets, including the ones under consideration.
Try:  Suite101.com outlines the difference between relative valuation and the more arduous, but thorough, discounted cash flow approach to valuing assets. Investopedia provides a broad outline and several cautionary notes about the limits of relative valuation.

Conduct a ratio evaluation to decide which yardstick you want to use

While analysts commonly refer to EBITDA ratios (Earnings Before Interest, Taxes, Depreciation, Amortization), you actually have several ratios to choose from, such as price to earnings ratio (P/E), price to sales ratio (P/S), even ratios based on book value or replacement cost. Review the various ratios and understand their relative merits before you continue your evaluation, then stick with those ratios to maintain consistency across your appraisals.
Try:  Morningstar outlines relative valuation along with common valuation ratios. NYU’s valuation expert Professor Aswath Damodaran hosts a site with a comprehensive glossary of valuation ratios you can use to compare companies.

Ensure accurate similarities between companies in your business comparisons

Firm comparisons can be less obvious than you think. Go beyond comparing two companies in the same industry. Look carefully for similarities and differences in size and growth potential, business structure or market models, or geographic locale. Choose a value analysis technique to analyze a company against the market as a whole or against itself by looking at its own history.
Try:  Familiarize yourself with firm valuation ratios by performing a valuation on your own business, or one you know, with a business valuation tool from Haleo. Then use the completed valuation as a benchmark to compare other companies, or other valuation tools to check for similarities or variations. For a quick study, Infinancials provides an Excel spreadsheet tool for you to download ratio tables of any number of over 70,000 companies worldwide for you to perform your own side-by-side comparisons.