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 val ...

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, 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 states the 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 fin ...

s or multiples, such as the price to book value, price to earnings,

EV/EBITDA Enterprise value/ EBITDA (more commonly referred to by the acronym EV/EBITDA) is a popular valuation multiple used to determine the fair market value of a company. By contrast to the more widely available P/E ratio (price-earnings ratio) it incl ...

, 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 in question will be priced relative to a benchmark, usually a

Government bond A government bond or sovereign bond is a form of Bond (finance), bond issued by a government to support government spending, public spending. It generally includes a commitment to pay periodic interest, called Coupon (finance), coupon payments' ...

. Here, the "required return" - technically the

yield to maturity The yield to maturity (YTM), book yield or redemption yield of a fixed-interest security is an estimate of the total rate of return anticipated to be earned by an investor who buys it at a given market price, holds it to maturity, and receives ...

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). It is the practice of predicting or forecasting the ability of a supposed debtor to pay back the debt or default. The ...

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

{{Reflist *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

Stock market Valuation (finance)

Equities

Individual equities

Equity indexes

Bonds

See also

References