Relative Valuation — P/E, EV/EBITDA, and Comparables

What is Relative Valuation? The "Comparison Shop" Approach

Imagine you're buying a house. You find a 2BHK apartment in Bangalore priced at ₹80 lakh. Is this a good price? To answer that, you'd look at what similar 2BHK apartments in the same area are selling for. If most similar apartments are priced at ₹75-85 lakh, the ₹80 lakh price is reasonable. If similar apartments are selling for ₹60-65 lakh, the ₹80 lakh price is expensive.

That's exactly what relative valuation does. Instead of calculating an absolute value (like DCF), it compares a company's valuation metrics to similar companies or to its own historical averages.

The logic is simple: if a company is similar to its peers but trades at a lower valuation, it might be undervalued. If it trades at a higher valuation, it might be overvalued — unless there's a good reason for the premium.

The Most Important Valuation Ratios

1. Price-to-Earnings (P/E) Ratio

The P/E ratio is the most widely used valuation metric. It tells you how much you're paying for each rupee of the company's earnings.

P/E Ratio = Market Price Per Share ÷ Earnings Per Share (EPS)

Or equivalently: P/E Ratio = Market Capitalization ÷ Net Profit

Example: If Reliance Industries has a market cap of ₹17,00,000 crore and net profit of ₹68,000 crore, the P/E ratio is 17,00,000 ÷ 68,000 = 25x.

This means you're paying ₹25 for every ₹1 of Reliance's earnings.

What P/E Tells You:

• A high P/E (say 40x) means investors expect high future growth. They're willing to pay more today for the promise of higher earnings tomorrow.
• A low P/E (say 10x) could mean the company is undervalued, OR it could mean the market expects low growth or perceives higher risk.

How to Use P/E for Indian Stocks:

Compare the P/E ratio to:

1. The company's own historical P/E (is it above or below its 5-year average?)
2. Its industry peers (is it cheaper or more expensive than competitors?)
3. The overall market P/E (the Nifty 50 P/E is typically 18-22x)

Typical P/E Ranges for Indian Sectors:

• IT Services: 25-35x (TCS, Infosys trade at premium P/Es due to high growth and quality)
• FMCG: 40-60x (HUL, Nestle trade at very high P/Es because of brand value and steady growth)
• Banking: 12-20x (HDFC Bank, ICICI Bank — P/E varies with credit cycle)
• Auto: 20-30x (Maruti, Bajaj Auto — depends on demand cycle)
• PSU: 5-12x (Coal India, ONGC — low P/Es due to government ownership and lower growth expectations)
• Pharma: 20-35x (Dr. Reddy's, Sun Pharma — varies with product pipeline)
• Real Estate: 30-80x (DLF, Godrej Properties — high P/Es because of asset-heavy valuations)

2. Price-to-Book (P/B) Ratio

The P/B ratio compares the company's market price to its book value (net worth).

P/B Ratio = Market Price Per Share ÷ Book Value Per Share

Or equivalently: P/B Ratio = Market Capitalization ÷ Net Worth

What P/B Tells You:

• P/B = 1 means the stock is trading at its book value
• P/B > 1 means the market values the company more than its net worth (investors believe the company will generate returns above its cost of equity)
• P/B < 1 means the stock is trading below book value (could be undervalued or the company is destroying value)

How to Use P/B for Indian Stocks:

P/B is particularly useful for:

• Banks and financial companies (where book value is a meaningful measure of the asset base)
• Asset-heavy companies (manufacturing, infrastructure)
• Companies with stable, predictable earnings

It's less useful for:

• IT services companies (minimal physical assets)
• FMCG companies (brand value not reflected in book value)
• Companies with intangible assets (pharmaceuticals, technology)

Typical P/B Ranges for Indian Sectors:

• Banking: 1.5-4x (HDFC Bank trades at 3-4x, PSU banks at 0.8-1.5x)
• IT: 8-15x (TCS trades at 12-15x due to high ROE)
• FMCG: 10-30x (HUL trades at 15-25x)
• PSU: 1-3x (Coal India at 3-4x, ONGC at 1-1.5x)
• Auto: 3-8x

3. EV/EBITDA Ratio

EV/EBITDA is a more comprehensive valuation metric than P/E because it considers the company's entire capital structure (both equity and debt).

EV (Enterprise Value) = Market Cap + Debt - Cash

EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization

EV/EBITDA tells you how much you're paying for each rupee of the company's operating earnings, regardless of how the company is financed.

Why EV/EBITDA is Better Than P/E:

1. It's capital structure neutral — a company with high debt won't look artificially cheap just because interest expense reduces its P/E.
2. It's useful for comparing companies with different debt levels.
3. It eliminates the impact of depreciation policies, which can vary between companies.

Typical EV/EBITDA Ranges for Indian Sectors:

• IT: 18-25x
• FMCG: 30-50x (very high due to high margins and low capital intensity)
• Banking: Not applicable (banking uses P/B instead)
• Auto: 12-20x
• Manufacturing: 10-18x
• PSU: 5-10x

4. Price-to-Sales (P/S) Ratio

P/S Ratio = Market Capitalization ÷ Revenue

This is useful for companies that are not yet profitable or have variable earnings. It tells you how much you're paying for each rupee of revenue.

When to Use P/S:

• Early-stage companies that are not yet profitable
• Companies with volatile earnings (cyclical industries)
• Comparing companies with different profit margins

Typical P/S Ranges:

• IT: 6-12x
• FMCG: 8-15x
• Banking: 3-6x
• Manufacturing: 2-5x
• Startups/Unprofitable: 1-10x (highly variable)

How to Do Comparable Company Analysis — A Step-by-Step Guide

Step 1: Identify Comparable Companies

Find companies that are similar in terms of:

• Industry/sector
• Size (market cap)
• Growth rate
• Business model
• Geographic focus

Example: To value Infosys, you might compare it with:

• TCS (direct competitor, similar size and business)
• Wipro (IT services, slightly smaller)
• HCL Technologies (IT services)
• Tech Mahindra (IT services)
• For global comparison: Accenture, Cognizant

Step 2: Gather Valuation Metrics

For each comparable company, calculate:

• P/E Ratio (trailing and forward)
• P/B Ratio
• EV/EBITDA
• P/S Ratio
• EV/Revenue
• Dividend Yield

Step 3: Calculate the Average and Median

For each metric, calculate the average and median across all comparable companies.

Step 4: Apply to the Target Company

Apply the average/median multiples to the target company's financial metrics to estimate its fair value.

Example — Valuing Infosys:

Comparable companies:

• TCS: P/E = 30x, EV/EBITDA = 22x
• Wipro: P/E = 22x, EV/EBITDA = 16x
• HCL Tech: P/E = 25x, EV/EBITDA = 18x
• Tech Mahindra: P/E = 35x, EV/EBITDA = 20x

Average P/E: 28x Median P/E: 27.5x

Infosys EPS: ₹65 Fair Value (using average P/E): ₹65 × 28 = ₹1,820 Fair Value (using median P/E): ₹65 × 27.5 = ₹1,788

If current price is ₹1,500, the stock appears undervalued based on peer comparison.

PEG Ratio — Combining Growth and Valuation

The PEG ratio adjusts the P/E ratio for the company's growth rate:

PEG Ratio = P/E Ratio ÷ Earnings Growth Rate

How to Interpret:

• PEG < 1: The stock is undervalued relative to its growth (good value)
• PEG = 1: The stock is fairly valued relative to its growth
• PEG > 1.5: The stock is expensive relative to its growth

Example:

Company A: P/E = 30, Growth = 20% → PEG = 30/20 = 1.5 (expensive) Company B: P/E = 20, Growth = 25% → PEG = 20/25 = 0.8 (undervalued)

Even though Company A has a higher P/E, Company B is actually better value because it's growing faster relative to its P/E.

Typical PEG Ranges for Indian Stocks:

• Large-cap growth stocks: 1.0-2.0 (TCS, HDFC Bank)
• Mid-cap growth stocks: 0.8-1.5 (Bajaj Finance, Asian Paints)
• Value stocks: 0.5-1.0 (Coal India, SBI)
• Expensive growth stocks: 2.0-4.0 (some FMCG and pharma stocks)

Historical Valuation Analysis — Is the Stock Cheap or Expensive?

Another powerful relative valuation technique is comparing a stock's current valuation to its own historical average.

How to Do Historical Valuation Analysis:

1. Collect historical data: Get the stock's P/E, P/B, and EV/EBITDA for the past 5-10 years.

2. Calculate the average and standard deviation: This tells you the "normal" valuation range for the stock.

3. Compare current valuation to the historical range:

   • If current P/E is below the historical average minus 1 standard deviation: Very cheap (potential buying opportunity)
   • If current P/E is near the historical average: Fairly valued
   • If current P/E is above the historical average plus 1 standard deviation: Expensive (potential selling opportunity)

Example — Historical P/E Analysis of HDFC Bank:

5-Year Average P/E: 25x Standard Deviation: 4x Current P/E: 20x

Current P/E (20x) is below the average minus 1 standard deviation (25 - 4 = 21x). This suggests HDFC Bank is trading at a historically cheap valuation.

Caution: A stock can be cheap for a reason. Always investigate WHY the stock is trading at a low valuation before buying. Maybe there's a genuine problem with the business.

When Relative Valuation Doesn't Work

Relative valuation has limitations:

1. No true comparables: If a company is truly unique (like a first-of-its-kind business in India), there may not be good comparable companies.

2. Cyclical earnings: During economic downturns, cyclical companies may have very low earnings, making their P/E ratios appear artificially high. In such cases, use EV/EBITDA or P/B instead.

3. Different accounting standards: Comparing companies with different accounting policies can be misleading.

4. Market sentiment: During bull markets, all stocks may be expensive relative to their historical averages. A stock that appears "cheap" relative to its history may still be overvalued in absolute terms.

5. Growth differences: Two companies in the same industry may have very different growth rates, making direct P/E comparison misleading. Use PEG instead.

Summary — Key Takeaways

1. Relative valuation compares a company's valuation metrics to similar companies or its own historical averages — it's like comparison shopping for stocks.

2. P/E is the most widely used metric but should be compared across peers and over time, not in isolation.

3. EV/EBITDA is better than P/E for comparing companies with different debt levels and is the preferred metric for many professional investors.

4. PEG ratio combines growth and valuation — stocks with PEG < 1 are often good value.

5. Historical valuation analysis helps you identify when a stock is cheap or expensive relative to its own past.

6. Never rely on a single metric — use multiple ratios (P/E, P/B, EV/EBITDA, PEG) to get a complete picture.

7. Always investigate WHY a stock appears cheap before buying — low valuation can be a value trap.