Wednesday, 02 May 2012 - 20:00

 

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Relative Valuation Methods

Anyone who has spent any time valuing a business, or its indivisible unit, a share in a business, knows that there is not one specific method, but rather a range of valuations methodologies that can be applied when formulating the valuation.

At its most basic level, the value of a share today is the discounted value of all future cash flows that will be generated from the share. While simple in theory, in order to try and determine a theoretical value, investment analysts spend a lot of time on forecasting a company’s future income stream. However, even armed with accurate information on future earnings for a specific company, because we live in a world with extensive investment choice, the investment process often comes down to making an assessment of one investment option relative to another.

This so called relative valuation methodology is widely used and in many respects is simpler than making an assessment of the value on an absolute basis. Ultimately investors have choice and so even after performing a thorough valuation, an investor will produce a ranking table in order to compare one investment option against other competing investments.

As with all investment tools there is not one method that is infallible so when adopting a relative valuation methodology, an investor is looking for certain relationship patterns that tend to hold over time.

A few examples of relative valuation techniques that investors use include the following:
• The earnings yield or dividend on shares relative to the current yield on money market or yield on property shares.
• The price of one share relative to another share – usually, but not necessarily, in the same sector.
• The price of one sector relative to another – or an index in one country relative to another country.
• The price of a share relative to its underlying book value over time to determine if relatively cheap or expensive.
• One currency relative to another currency.

Even one of the most common valuation methods used – the price to earnings – or PE method is in essence a relative valuation method, when extended to comparing a company’s PE to the market average PE. With this method, company’s actual earnings are defined as a ratio to the number of shares in issue to arrive at earnings per share (EPS). Once the common yardstick has been obtained in the form of the PE, then it becomes easy to compare one traded share price to another in a relative format.

Look at the chart below, which compares the PE ratio of Anglo American relative to the PE ratio of Massmart over a 10 year period. This so called PE relative chart is a common tool used by analysts to gauge where value is appearing. This chart does not imply that either share is attractive or unattractive in its own right, but it gives a clear sense of the relative outperformance of Massmart against Anglo American over 10 years.

PE relative of Anglo American to Massmart

Source: I-Net and Seed Investments

Ten years ago, Anglo American had a PE ratio of 18 compared to Massmart’s 8. While the PE ratios have, on average, been almost equal over the past 10 years Anglo American’s PE has declined to 8 compared to Massmart’s 34 – i.e. one quarter of Massmart’s PE and a deterioration of some 90% over this time frame.

Analysts will say things like Anglo American looks cheap relative to the market or relative to consumer shares. There may be very valid reasons why one company’s valuation has deteriorated on a relative basis over time, but this is where an analyst should do additional work in order to make an assessment of the fundamental reasons. So by all means, make use of relative valuation techniques. They can be very powerful, but in and by themselves they will not tell the full story.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Wed, 02 May 2012

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