# Relative Valuation: An In-Depth Look

Relative valuation, also known as comparable valuation, is a method used to determine the value of different assets including bonds, real estate, and equities.

This technique involves comparing the asset in question with other similar assets to derive its value.

Let’s look into how relative valuation is applied across different asset types.

## Key Takeaways – Relative Valuation

Relative Valuation Methods: Relative valuation involves comparing assets to similar ones in the market to determine their value. This technique simplifies valuation by leveraging the prices and characteristics of comparable assets.Applications: Relative valuation is applied across different asset types such as bonds, real estate, and equities. Each asset type employs specific metrics and ratios to assess value within its unique context.Comparables and Context: Successful relative valuation relies on selecting appropriate comparables and understanding market dynamics. This approach provides insights into asset value but requires careful consideration of the chosen benchmarks and their relevance to the asset being valued.

## Relative Valuation in Bonds

Bonds are debt securities that corporations and governments issue to raise capital.

### Bond Valuation: Relative Price Approach

In the relative price approach, bonds are compared based on their prices.

This process involves comparing the prices of a bond with similar characteristics.

These characteristics can include the type of issuer, maturity date, coupon rate, and credit rating.

### Yield Spread

Yield spread is a key indicator of the risk associated with a specific bond when compared to a risk-free bond (i.e., no credit risk in cases where the government can always pay its bills in nominal terms), such as a government bond.

There are several types of yield spreads.

#### I-spread

The I-spread (Interpolated spread) is the difference between the yield of a specific bond and the yield of a benchmark bond, interpolated on the swap curve.

#### Option-Adjusted Spread (OAS)

Option-Adjusted Spread takes into consideration the embedded options within a bond, adjusting the spread to reflect these options’ potential effects.

#### Z-spread

The Z-spread or Zero-volatility spread, adjusts the discount rate until the present value of a bond’s cash flow equals its market price.

#### Asset Swap Spread

The Asset Swap Spread is the spread that makes the bond’s cash flows equal to the interbank reference rates plus the spread when swapped for a floating rate.

### Credit Spread (Bond)

Credit spread represents the additional yield that a bond investor demands for taking on credit risk.

It’s dependent on the bond’s credit rating.

#### Bond Credit Rating

A bond credit rating assesses the creditworthiness of a corporation’s or government’s debt issues.

It provides investors with an indication of the risk factor associated with investing in a bond.

#### Altman Z-score

The Altman Z-score is a formula that measures a company’s financial health to predict the probability of it going bankrupt.

#### Ohlson O-score

The Ohlson O-score predicts the likelihood of a company’s financial distress, such as bankruptcy, based on several financial variables.

### Financial Ratios in Bond Valuation

Certain financial ratios are used to assess the company’s financial health, impacting the bond’s relative valuation.

#### Book Value

The book value is the total value of a company’s assets that shareholders would theoretically receive if a company were liquidated.

#### Debt-to-Equity Ratio

The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets.

#### Debt-to-Capital Ratio

The debt-to-capital ratio measures a company’s financial leverage.

It compares a company’s total debt to its total capital, which is the sum of debt and equity.

#### Current Ratio

The current ratio measures a company’s ability to pay its short-term liabilities with its short-term assets.

#### Quick Ratio

The quick ratio, also known as the acid-test ratio, measures a company’s ability to pay its short-term liabilities without selling inventory.

### Bonds vs. Gold

Relative valuation between government bonds and gold hinges on yield and currency value perceptions.

Government bonds offer explicit yields (usually), while gold doesn’t.

However, when bond yields are low and the currency’s value is likely to decline against gold (e.g., due to poor government finances), gold can become more relatively attractive.

It acts as a hedge against currency devaluation and other unknowns associated with traditional financial securities, even without offering a traditional yield.

Traders/investors may pivot to gold, viewing its preservation of value as a form of “implicit yield” when nominal yields are unattractive or real yields (adjusted for inflation) turn negative.

## Relative Valuation in Real Estate

Relative valuation in real estate involves comparing a property to similar properties in the same geographic area to determine its value.

### Capitalization Rate

The capitalization rate, also known as the cap rate, is used in real estate to estimate the potential return on an investment.

It is calculated by dividing the property’s net operating income by its market value.

### Gross Rent Multiplier

The Gross Rent Multiplier (GRM) is a simple method used to assess the value of a property.

It is calculated by dividing the property’s price by its gross annual rental income.

### Sales Comparison Approach

The sales comparison approach (SCA) is a method for estimating the value of a property by comparing it to similar properties that have recently been sold.

### Cash on Cash Return

The cash on cash return is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property.

## Relative Valuation in Equity

Equity valuation is the process of determining the fair value of a company’s shares.

Various methods can be used, many of which employ financial ratios and multiples.

### Financial Ratio

Financial ratios are mathematical comparisons of various financial statement accounts or categories.

These relationships between the financial statement accounts help investors, creditors, and internal company management understand how well a business is performing.

### Market-based Valuation

Market-based valuation methods assign a value to a company based on how similar firms are priced in the stock market.

### Valuation using Multiples

Valuation using multiples involves comparing a company’s financial metrics (like earnings or book value) with that of other companies.

Commonly used multiples include the P/E (Price-to-Earnings), P/B (Price-to-Book), and EV/EBITDA (Enterprise Value to EBITDA) ratios.

### Comparable Company Analysis

Comparable company analysis (CCA) is a method of valuation that compares the financial metrics and ratios of a company to those of similar companies in the same industry.

### Dividend Yield

Dividend yield measures the return on investment for a stock based on the dividends received.

A higher dividend yield may not necessarily mean a greater return on investment for a stockholder, but it shows that the company prioritizes returning cash to shareholders in some way.

#### Yield Gap

The yield gap is the difference between the dividend yield of a stock and the yield of a long-term, risk-free government bond.

This is similar to the Fed Model that compares long-term government bond yields with the earnings yield in a stock index.

### Return on Equity

Return on Equity (ROE) measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.

#### DuPont Analysis

The DuPont Analysis is a framework that decomposes the ROE into several components, helping to understand the source of a company’s profitability.

### Price-to-Earnings Ratio

The Price-to-Earnings (P/E) ratio is a valuation ratio that compares a company’s current share price to its earnings per share (EPS).

#### PEG Ratio

The PEG (Price/Earnings to Growth) ratio is a valuation metric that adjusts the P/E ratio by the growth rate of the company’s earnings.

#### Cyclically Adjusted Price-to-Earnings Ratio (CAPE)

The CAPE ratio is a valuation measure that uses real per-share earnings over a 10-year period to smooth out fluctuations in corporate earnings caused by business cycles.

#### PVGO

Present Value of Growth Opportunities (PVGO) is a component of a company’s market value that is attributed to growth opportunities.

### Price-to-Book Ratio

The Price-to-Book (P/B) ratio compares a firm’s market capitalization to its book value.

### Price to Cash Based Earnings

This valuation method uses cash flows instead of net income to find the relative value of a stock.

### Price to Sales

Price to Sales (P/S) is a valuation ratio that compares a company’s stock price to its revenues.

### EV/EBITDA

EV/EBITDA is a ratio that compares a company’s Enterprise Value to its Earnings Before Interest, Taxes, Depreciation, and Amortization.

### EV/Sales

EV/Sales is a financial ratio that compares the enterprise value of a company to the company’s sales.

### Stock Image

Stock image is the perception of a company’s equity in the mind of investors.

### Valuation Using the Market Penetration Model

The market penetration model values a company based on its potential for market penetration and future growth.

### Graham Number

The Graham Number, named after Benjamin Graham, the father of value investing, is a measure of a stock’s fundamental value independent of its market price.

### Tobin’s q

Tobin’s q, named after the Nobel laureate James Tobin, is the ratio of a company’s market value to its replacement cost.

It is a signal of a company’s growth prospects and market value relative to the value of its assets.

## Conclusion

Relative valuation is a widely used method for asset valuation, as it takes into consideration the value of similar assets in the market.

While this approach simplifies the complex process of valuation, it also emphasizes the importance of choosing the right comparables and understanding the market dynamics affecting these assets.

For accurate and insightful valuations, it’s important to understand the different methods and techniques involved in relative valuation across various assets like bonds, real estate, and equities.