INVESTOR LETTER #113
Relative Valuation
Relative valuation is the process of estimating a company's value by comparing it with similar businesses instead of calculating its intrinsic value directly. Investors use valuation ratios such as P/E, EV/EBITDA, P/B, or Price-to-Sales to determine whether a company appears expensive or cheap compared to its peers. While this approach is simple and widely used, it should never replace understanding the business itself.
INVESTOR NOTE
A business owner thinks in decades. A speculator thinks in minutes.
Choosing Between Two Similar Houses
Imagine you're buying a house in a neighborhood you've never visited before. Instead of estimating exactly what the house is worth, you look at what similar houses nearby have recently sold for. If every comparable house sold for around ₹1 crore and one owner is asking ₹75 lakh, you naturally become interested. If another owner asks ₹2 crore, you start asking questions. This is exactly how relative valuation works.
What Is Relative Valuation?
Relative valuation estimates a company's value by comparing it with similar companies. Instead of asking, 'What is this business intrinsically worth?', it asks, 'How is this business priced compared with other businesses like it?'
Finding the Right Comparison
Comparing completely different businesses rarely makes sense. A software company, a steel manufacturer, and a bank all operate under different economics. Relative valuation works best when comparing businesses that serve similar customers, operate in the same industry, and have similar growth and profitability.
Why Investors Like This Method
Relative valuation is quick and practical. Instead of forecasting cash flows for decades, investors can compare valuation multiples across similar companies. That's one reason analysts, fund managers, and investment bankers use it so frequently.
Cheap Compared to What?
A company trading at a P/E of 18 may seem expensive until you discover that every comparable business trades above 30. On the other hand, a stock trading at a P/E of 10 may look attractive until you realize its competitors trade at similar valuations because the entire industry faces challenges.
The Market Can Be Wrong Together
One of the biggest weaknesses of relative valuation is that it assumes the market is pricing comparable companies correctly. But sometimes an entire industry becomes overvalued during periods of optimism or undervalued during times of fear. Comparing one overpriced company with another overpriced company doesn't make either one cheap.
Quality Still Matters
Two companies may operate in the same industry but deserve different valuations. A business with stronger management, higher returns on capital, better margins, lower debt, and a durable competitive advantage usually deserves to trade at a premium.
Growth Changes Everything
Imagine two retail companies with the same P/E ratio. One is growing profits at 20% a year while the other is barely growing. Looking only at the valuation multiple ignores a major difference in future potential. Relative valuation should always be combined with growth analysis.
Use More Than One Metric
No single valuation ratio tells the complete story. Professional investors often compare several measures such as P/E, EV/EBITDA, P/B, Price-to-Sales, and Free Cash Flow Yield before drawing conclusions. Looking at multiple perspectives reduces the chance of making decisions based on one misleading number.
A Starting Point, Not the Finish Line
Relative valuation is excellent for generating ideas, but it cannot tell you what a business is truly worth. It should encourage further research, not replace it. Understanding the company's business model, management, competitive advantages, and future prospects remains essential.
Great Investors Use Both Approaches
Many experienced investors estimate a company's intrinsic value using methods like DCF and then compare that valuation with similar businesses in the market. If both methods point toward the same conclusion, confidence in the investment decision usually increases.
One Question Before Comparing Companies
Whenever you compare two companies, ask yourself: 'If I ignored their stock prices completely, would I still believe these businesses deserve similar valuations?' If the answer is no, then a simple comparison of valuation multiples may not tell the full story.
INVESTOR PRINCIPLE