Relative valuation also called
valuation using multiples
In economics, valuation using multiples, or " relative valuation", is a process that consists of:
* identifying comparable assets (the peer group) and obtaining market values for these assets.
* converting these market values into standardized va ...
is the notion of comparing the price of an asset to the market value of similar assets. In the field of securities investment, the idea has led to important practical tools, which could presumably spot pricing anomalies. These tools have subsequently become instrumental in enabling analysts and investors to make vital decisions on asset allocation.
Equities
In
equities
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
, the concept separates into two areas—one pertaining to individual equities and the other to indices.
Individual equities
The most common method for individual equities is based on comparing certain
financial ratio
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financia ...
s or multiples, such as the
price to book value,
price to earnings,
EV/EBITDA, etc., of the equity in question to those of its peers. This type of approach, which is popular as a strategic tool in the financial industry, is mainly statistical and based on historical data.
Equity indexes
For an equity index the above fails mainly because it is difficult to group indices into peer groups. Consequently, relative valuation here is generally carried out by comparing a national or industry stock index’s performance to the economic and market fundamentals of the related industry or country.
Those fundamentals may include GDP growth, interest rate and inflation forecasts, as well as earnings growth, among others. This style of comparison is popular among practising economists in their attempt to rationalise the connections between the equity markets and the economy.
National equity index are not fully relevant in this respect due to the proportion of multinational companies listed in most national stock markets.
Bonds
In
valuing a bond, the
bond
Bond or bonds may refer to:
Common meanings
* Bond (finance), a type of debt security
* Bail bond, a commercial third-party guarantor of surety bonds in the United States
* Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
in question will be priced relative to a benchmark, usually a
Government bond. Here, the "required return" - technically the
yield to maturity or YTM - on the bond is determined based on the bond's
Credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
relative to a government security with similar maturity. The better the quality of the bond, the smaller the spread between its YTM and the YTM of the benchmark. See
Bond valuation# Relative price approach.
References
*R.D. Cohen (2005) "The Relative Valuation of an Equity Price Index
download Chapt. 9 in ''Best of Wilmott'', Vol. 2.
*R.D. Cohen (2009) "Constructing a ''GDP''-based Index for Use as Benchmark
See also
*
Market-based valuation A Market-based valuation is a form of stock valuation that refers to market indicators, also called extrinsic criteria (i.e. not related to economic fundamentals and account data, which are intrinsic criteria).
Examples of market valuation methods ...
*
Valuation using multiples
In economics, valuation using multiples, or " relative valuation", is a process that consists of:
* identifying comparable assets (the peer group) and obtaining market values for these assets.
* converting these market values into standardized va ...
*
Outline of finance #Relative valuation
Stock market
Valuation (finance)