Relative Valuation Model: Definition, Steps, and
Types of Models
By Tobi Opeyemi Amure Updated April 28, 2025
What Is a Relative Valuation Model?..................................................................................................................................1
Definition of Relative Valuation Model................................................................................................................................2
Comparison with Absolute Valuation Models.....................................................................................................................2
Key Metrics and Ratios Used in Relative Valuation...........................................................................................................2
Price-to-Earnings (P/E) Ratio............................................................................................................................................2
Enterprise Value (EV) Ratios............................................................................................................................................3
Other Common Ratios.......................................................................................................................................................3
Steps in Conducting a Relative Valuation............................................................................................................................3
Types of Relative Valuation Models.....................................................................................................................................4
Market Multiple Models....................................................................................................................................................4
Comparable Company Analysis........................................................................................................................................4
Precedent Transactions Analysis.......................................................................................................................................4
Advantages and Limitations of Relative Valuation Models...............................................................................................5
Advantages........................................................................................................................................................................5
Disadvantages....................................................................................................................................................................5
The Bottom Line.....................................................................................................................................................................5
A relative valuation model is a tool used to value companies and compare them to each other by using particular
metrics.
What Is a Relative Valuation Model?
- financial tool for comparing a company’s value to that of similar companies.
- Rather than valuing a business on its own internal metrics, this approach asks: How does the company
stack up against its peers or industry averages?
By examining market valuations of comparable firms, analysts can gauge whether a stock appears overvalued,
undervalued, or fairly priced relative to others in its field. This provides market-based context for making
investment decisions.
● Relative valuation compares a company to similar firms using metrics such as
(1) price to earnings;
(2) enterprise value to earnings before interest, taxes, depreciation, and amortization;
(3) price to sales ratio; and
(4) price to cash flow.
● Relative valuation reflects market sentiment by showing how investors price comparable assets.
(investor based valuing)
● Analysts typically identify comparable companies, select relevant ratios, and compare them to gauge
relative value.
● Common methods include
market multiples,
comparable company analysis, and
precedent transactions analysis.
● Relative valuation is simple and widely used, but its accuracy depends on peer companies being
correctly valued. (accuracy depends on peers, wrong peer value, wrong industry valuation)
Definition of Relative Valuation Model
A relative valuation model estimates a company’s worth by comparing it to other companies'. It uses financial
ratios or multiples of similar businesses to judge the company’s value. The idea is that companies with similar
operations should trade at similar multiples.
If one company’s metrics, such as its price-to-earnings ratio, are out of line with those of its peers, it could
indicate that the stock is mispriced. For example, if peers trade around 10x earnings and one company trades at
5x, that company looks undervalued relative to the group. Relative valuation models, therefore, rely on peer
valuations, rather than on intrinsic value calculations.
Bridger Pennington, co-founder of Fund Launch, emphasizes: "Valuation isn't done in isolation; it's guided by
how similar companies are trading."
Comparison with Absolute Valuation Models
Absolute valuation calculates intrinsic value based on a company's future cash flows, without referencing
market comparisons. Common methods include discounted cash flow (DCF) analysis. In contrast, relative
valuation focuses on current market prices of comparable companies to evaluate a stock’s worth.
Pennington highlights this difference clearly: "Absolute valuation is about what a company is fundamentally
worth; relative valuation is about what others are willing to pay."
Analysts typically use both methods. Absolute valuation provides foundational value, while relative valuation
confirms this through market data. Together, they offer a more comprehensive understanding of a company's
worth.
Key Metrics and Ratios Used in Relative Valuation
Analysts use several key valuation multiples to compare companies. The choice of metric depends on the
industry and what drives value. Common ratios include:
Price-to-Earnings (P/E) Ratio
- calculated by dividing a stock’s price by its earnings per share.
- shows how much investors are paying for each dollar of earnings.
- In a relative valuation, a company’s P/E is compared to those of other companies.
A higher P/E than peers indicates the stock is potentially overvalued, while a lower P/E suggests it’s potentially
undervalued. For example, if the average P/E in an industry is 15 and Company A’s P/E is 8, Company A looks
undervalued compared to its peers.
Enterprise Value (EV) Ratios
- total value of a company (equity plus debt minus cash).
- A common EV-based metric is EV/EBITDA, which divides enterprise value by earnings before interest,
taxes, depreciation, and amortization.
This ratio allows comparison of companies regardless of their capital structure, since it factors in debt and uses
a pre-interest earnings measure. If one company’s EV/EBITDA is lower than those of similar companies, it may
be undervalued on this basis.
Analysts also use EV/Sales (enterprise value to sales) for situations where earnings are negative or not
meaningful, such as early-stage companies.
Other Common Ratios
Other multiples are used depending on the industry:
● Price-to-Sales (P/S): Market capitalization divided by annual sales. Often used for companies without
profits (e.g., early-stage tech), as it focuses on revenue. A low P/S relative to peers could indicate an
undervalued stock.
● Price-to-Cash-Flow: Stock price divided by cash flow per share (operating or free cash flow). Useful
for firms where cash flow diverges from net income (e.g., companies with heavy non-cash charges). A
low P/CF relative to peers suggests the stock may be undervalued.
Each sector tends to have favored metrics. For instance, banks often use price-to-book value, while telecom and
utility companies might emphasize EV/EBITDA. The key is selecting ratios that best capture how investors
value companies in that particular sector.
Steps in Conducting a Relative Valuation
Here are the necessary steps to conduct a relative valuation:
● Identify Comparable Companies: First, identify comparable companies (“comps”) in the same
industry with similar size and business models. The idea is to compare the target company to peers that
mirror its operations as closely as possible. The analysis is only as good as the peers chosen. Pennington
notes, “If your comparables aren’t truly comparable, the multiples can mislead you.”
● Select Relevant Ratios: Next, choose the valuation ratios that fit the company and industry. Different
industries focus on different metrics. For example, you might use P/E and dividend yield for a utility
company, but rely on P/S or user-based metrics for a high-growth tech startup that has little or no
earnings. The goal is to use measures that reflect what investors care about for that type of business. As
Pennington says, “Every industry has its key metrics—you wouldn’t value a new software firm on P/E
alone.”
● Calculate and Compare Ratios: Then, calculate the selected ratios for the target and each peer, and
compare the results. If the target’s ratios are higher than its peers', its stock is relatively expensive; if
lower, it’s relatively cheap. If most peers trade around 10x earnings, and the target is at 8x, it appears
undervalued by that metric.
It’s important to consider why the discrepancy exists: a low multiple might indicate an opportunity, or it
could be a reflection of company-specific issues. This comparative step reveals where the company
stands in the context of its peers in the market.
Types of Relative Valuation Models
Market Multiple Models
These models apply an average market multiple from comparable companies to the target’s financial results to
estimate its value. For example, let's say comparable firms trade at an average of 5× sales, and the target
company has $200 million in sales. In this scenario, a market multiple approach would suggest a valuation of
about $1 billion (5 × $200M) for the target’s equity.
Market multiple models are straightforward to use and tie the valuation directly to prevailing market
benchmarks. The key is ensuring the multiple used is representative of the peer group and not skewed by
outliers.
Comparable Company Analysis
Comparable company analysis (CCA) involves a side-by-side comparison of key multiples for a group of
similar companies to see where the target falls. This provides a nuanced view of valuations, showing the range
among peers rather than a single average. Using this information, the analyst can estimate a fair value range for
the target. If most peers trade between 8× and 10× EBITDA, the target will likely fall in that band, barring
unique factors.
Precedent Transactions Analysis
This approach examines valuation multiples from past acquisition deals involving similar companies. By
looking at what acquirers paid—say, that several recent buyouts in the industry happened around 12× EBITDA
—an analyst can gauge what the target might be worth in a takeover scenario.
Precedent transaction multiples typically include a control premium (buyers pay extra to control the company),
so they often come out higher than everyday trading multiples.3 This analysis is especially useful in mergers and
acquisitions to establish an upper bound of value based on real-world transaction data.
Advantages and Limitations of Relative Valuation Models
Advantages
● Simplicity
● Market Relevant
● Comparative Insight
● Benchmarking
Disadvantages
● Market Mispricing
● Lack of True Comparables
● Limited Perspectives
Advantages
● Simplicity: Easy and quick to perform with readily available data, unlike complex intrinsic valuation
models that require many assumptions.
● Market Relevant: Reflects current market sentiment and industry trends by using actual pricing of
comparable businesses.
● Comparative Insight: Highlights whether a stock is trading at a premium or discount to its peers,
helping identify potential overpricing or underpricing.
● Benchmarking: Serves as a market-based check. It can validate or flag discrepancies when compared
against valuations derived from other methods (like a DCF model).
Disadvantages
● Market Mispricing: If an entire sector is mispriced, a relative valuation will reflect that. Pennington
cautions that “being ‘cheap’ relative to overpriced peers doesn’t guarantee a bargain.”
● Lack of True Comparables: It’s often hard to find identical comparables. Companies can differ in size,
growth, or accounting, which can skew the analysis.
● Limited Perspective: Relative models give a snapshot based on current data. They don’t account for a
company’s future prospects or risks. A stock might look undervalued versus peers but still be a poor
investment if its outlook is weak, and the reverse can also hold true.
The Bottom Line
Relative valuation models offer a quick, market-driven way to gauge a company’s value relative to peers, and
they are popular for their simplicity and insights. However, investors should be careful not to rely on relative
analysis alone. The best approach is to use relative valuation alongside absolute methods, combining market
perspective with fundamental analysis to make well-informed decisions. Considering both relative and absolute
valuations helps investors gain a more complete picture of a stock’s worth.