Imagine for a moment that you are shopping for a new house. After weeks of searching, you find a beautiful three-bedroom home listed for $500,000. Is that a good deal?
If you look at the house in isolation, you have absolutely no idea. It might be the deal of the century, or it might be wildly overpriced. However, if you look at the house next door, which is the exact same size, age, and condition, and see that it just sold for $750,000, you immediately know the first house is a bargain.
This process is called Relative Valuation.
In the stock market, we don’t buy houses; we buy businesses. However, the logic remains exactly the same. Relative valuation is the financial art of comparing a company’s price to the market value of similar companies (its peers) to determine if it is cheap (undervalued) or expensive (overvalued).
The Golden Rule: Apples to Apples
Before you ever open a calculator, you must understand the most critical rule of relative valuation: Comparability.
A common mistake beginners make is comparing companies that have nothing in common. For example, you cannot compare a high-growth software company to a junior gold mining operation. They have completely different business models, profit margins, and risk profiles. That is the definition of comparing apples to oranges, and your analysis would be useless.
To get a true relative valuation, you must first create a Peer Group. This involves selecting a basket of companies that operate in the same industry, are roughly the same size, and have similar growth prospects. If you are valuing a telehealth company, you must compare it to other telehealth companies, not to banks or oil producers.
The Toolkit: Metrics You Need to Know
To compare these companies, we use “multiples.” A multiple is simply a ratio that divides a company’s market value by a specific financial metric, such as its sales or its cash flow. While there are many ratios out there, you need to understand the difference between Market Cap and Enterprise Value to get started.
Why Market Cap isn’t Enough
Most beginners look at Market Cap (Stock Price multiplied by the Number of Shares) and stop there. While Market Cap tells you how much the shares are worth, it is flawed because it ignores the company’s bank account and its debts.
Professionals prefer to use Enterprise Value (EV).
Think of Enterprise Value as the “Takeover Price.” If you wanted to buy the entire company today, you would have to pay the shareholders their market value, but you would also become responsible for paying off the company’s debts. However, to sweeten the deal, you would get to keep whatever cash is currently sitting in the company’s bank account.
The formula looks like this:
EV = Market Cap + Total Debt − Cash
To visualize this, imagine buying a house for $500,000 (Market Cap). If that house has a $200,000 mortgage lien on it that you must pay off, the real cost to you is $700,000. But, if the previous owner left $50,000 in cash on the kitchen table for you, the real cost drops to $650,000. That final number, $650,000, is the Enterprise Value.
Selecting the Right Multiple
Once we have the Enterprise Value, we divide it by a performance metric to create a ratio.
EV/Sales is a ratio calculated by dividing the Enterprise Value by the total revenue. This is best used for high-growth companies (like tech startups) that aren’t profitable yet. It tells you how much investors are willing to pay for every dollar of sales the company generates.
EV/EBITDA is calculated by dividing Enterprise Value by Operational Profit (EBITDA). This is generally preferred for established companies with stable profits, like Coca-Cola or Waste Management. It effectively tells you how many years it would take for the company to earn back its purchase price using its current cash flow.
The Case Study: The “Burger Wars”
Let’s look at a detailed hypothetical scenario to see how this works in practice. We want to value a company called Burger Kingpin. We aren’t sure if it is a good investment, so we are going to compare it to its two main competitors: Patty Palace and Bun Brothers.
Here is the raw data for our peer group:
| Metric | Burger Kingpin (Target) | Patty Palace (Peer) | Bun Brothers (Peer) |
| Stock Price | $10.00 | $25.00 | $50.00 |
| Enterprise Value (EV) | $120M | $600M | $1,000M |
| Annual Sales | $40M | $150M | $200M |
| EBITDA (Profit) | $10M | $60M | $125M |
Note: Even though Burger Kingpin has the lowest stock price ($10), that does not mean it is the cheapest company. We have to run the ratios to find the truth.
Crunching the Numbers
First, let’s look at the Revenue multiple (EV/Sales). If we take Burger Kingpin’s Enterprise Value of $120M and divide it by their sales of $40M, we get a multiple of 3.0x. When we do the same math for the competitors, we see that Patty Palace trades at 4.0x sales, and Bun Brothers trades at 5.0x sales.
Next, let’s look at the Profit multiple (EV/EBITDA). Burger Kingpin has an EV of $120M and EBITDA of $10M, resulting in a multiple of 12.0x. Meanwhile, Patty Palace trades at 10.0x, and Bun Brothers trades at a very low 8.0x.
The Comparison
| Company | EV/Sales Multiple | EV/EBITDA Multiple | Valuation Status |
| Burger Kingpin | 3.0x | 12.0x | ? |
| Patty Palace | 4.0x | 10.0x | Peer |
| Bun Brothers | 5.0x | 8.0x | Peer |
| Peer Average | 4.5x | 9.0x | Benchmark |
Analyzing the Results
This is where the art of investing comes into play, because the data tells us two conflicting stories.
Based on Sales, Burger Kingpin appears Undervalued. It is trading at 3.0x sales while the peer average is 4.5x. This suggests that for every dollar of revenue the company brings in, you are paying less for Burger Kingpin than you would be for its competitors.
However, based on Profit (EBITDA), Burger Kingpin appears Overvalued. It is trading at 12.0x profit, while the peer average is only 9.0x. This means you are paying a premium for Burger Kingpin’s current cash flow.
A likely conclusion here is that Burger Kingpin is a younger, smaller company. It is generating sales efficiently (which makes it cheap on sales), but it hasn’t figured out how to turn those sales into profit as well as “Bun Brothers,” which is likely a massive, efficient machine trading at a cheaper profit multiple.
The “Value Trap” and The “Premium”
Relative valuation is not a crystal ball. Just because a stock has a lower multiple than its peers doesn’t automatically mean you should buy it.
Sometimes a company is cheap for a very good reason. This is called a Value Trap. If a company is trading at a significantly lower multiple than the rest of the industry, the market might be pricing in a future bankruptcy, a massive lawsuit, or a dying business model. Buying a stock solely because the multiple is low is like buying discounted sushi from a gas station, sometimes the discount isn’t worth the risk to your health.
Conversely, some companies always trade at higher multiples, known as a Quality Premium. Think of companies like Costco or Apple. They are rarely “cheap” compared to their peers. They trade at a premium because they have massive competitive advantages, world-class management teams, or incredibly clean balance sheets. In these cases, analysts are willing to pay a higher multiple for the safety and reliability that the company provides.
Summary
Relative valuation is a filtering tool. It helps you ask the right questions. By calculating the Enterprise Value and comparing the multiples of a target company against a peer group, you can strip away the noise of the stock price and see the true value of the business.
If the company is undervalued, you must ask yourself if you have found a hidden gem or a value trap. If it is overvalued, you must decide if the premium is justified by superior management or faster growth.
