Relative Valuation

Relative valuation estimates a firm’s value by benchmarking it against other companies that operate in the same industry and have similar risk‑return characteristics. Instead of forecasting cash flows, the analyst uses observable market prices of peers to infer a reasonable price for the target.

The underlying assumption is that the market efficiently prices comparable firms, so any systematic difference between the target and its peers can be captured through a ratio of a financial metric (e.g., earnings, book value) to the market price. This approach is especially useful when reliable cash‑flow forecasts are difficult to obtain.

For the NISM exam, you must know that relative valuation is a “market‑based” method, distinct from discounted cash‑flow (DCF) which is a “fundamental” method. Questions often ask you to choose the appropriate multiple or to adjust a multiple for differences in growth or leverage.

• Key benefit: quick and market‑driven.
• Key risk: depends on the quality of comparable selection.

The Indian equity market commonly uses four price multiples: Price‑Earnings (P/E), Price‑Book (P/BV), Enterprise‑Value to EBITDA (EV/EBITDA), and Price‑Sales (P/S). Each multiple relates a market price to a different underlying economic driver, allowing analysts to focus on earnings, balance‑sheet strength, operating cash flow, or revenue respectively.

SEBI’s guidelines for research analysts emphasize that the chosen multiple must reflect the dominant value driver of the industry. For example, banks are typically valued with P/BV because book value captures capital adequacy, while technology firms are often valued with EV/EBITDA due to high depreciation and amortisation.

On the exam, you may be given a set of multiples for a peer group and asked to compute the implied price for the target. Remember to keep the units consistent – all multiples are expressed in “times” and the market price is in rupees per share.

Step 1 – Define the valuation objective and select the appropriate multiple based on the industry’s value driver. For a bank, you would typically pick P/BV; for a pharma company, P/E may be more relevant.

Step 2 – Identify a peer group of 3‑5 listed companies that are similar in size, growth, capital structure and regulatory environment. SEBI expects analysts to justify peer selection with clear criteria.

Step 3 – Collect the latest financial data for each peer, compute the chosen multiple, and calculate the average (mean or median) multiple. The median is often preferred to reduce the impact of outliers.

Step 4 – Apply the average multiple to the target’s corresponding metric using the formula above. Adjust for any material differences (e.g., growth, leverage) before finalising the implied price.

Peers must be listed on the same exchange (NSE or BSE) and have a market‑cap within ±30% of the target. This ensures that the price‑multiple reflects similar liquidity and investor perception.

Beyond size, analysts examine growth rates, dividend policies, and capital structure. For instance, a high‑leverage peer can distort EV/EBITDA, so a low‑leverage peer is preferred when using that multiple.

In exam questions, you may be given a table of potential peers and asked to eliminate those that do not meet the criteria. Remember to check for recent mergers, regulatory bans, or suspension of trading, as these affect comparability.

When the target’s growth rate differs materially from the peer average, analysts adjust the multiple upward or downward. A common rule of thumb is to add 0.5‑1.0 times the percentage point difference in expected earnings growth to the P/E multiple.

Another adjustment involves normalizing for one‑time items. If a peer reported an extraordinary gain, the analyst should remove that gain from earnings before computing the P/E, ensuring the multiple reflects sustainable earnings.

For the exam, you may be asked to compute an “adjusted P/E” using a given growth differential. Apply the adjustment first, then use the adjusted multiple in the valuation formula.

Relative valuation assumes that the market has correctly priced the peers, which may not hold during market bubbles or sector‑wide distress. Consequently, the derived price can inherit the same mispricing.

Another limitation is the sensitivity to the choice of multiple. Using P/E for a capital‑intensive firm can be misleading, while EV/EBITDA may better capture operating performance.

Common exam mistakes include: (i) mixing up market price with market capitalisation, (ii) forgetting to annualise quarterly metrics before computing multiples, and (iii) ignoring currency conversion when comparing Indian peers with foreign ADRs.

Memorise the four core multiples and their typical industry applications – a quick table in your revision notes saves time. When a question provides multiple peers, calculate the median rather than the mean unless the syllabus explicitly asks for the average.

Always check the unit of the metric (per share vs total) before plugging numbers into the formula. The NISM exam frequently includes a distractor where the metric is given in total rupees, leading to an inflated price if not converted.

Finally, write a brief justification for your peer selection and any adjustments. Even if the answer is multiple‑choice, the rationale can help you eliminate wrong options and earn partial credit in case of negative marking.