what is a relative valuation model 
a relative valuation model is a business valuation method that compares a company s value to that of its competitors or industry peers to assess the firm s financial worth relative valuation models are an alternative to absolute value models which try to determine a company s intrinsic worth based on its estimated future free cash flows discounted to their present value without any reference to another company or industry average like absolute value models investors may use relative valuation models when determining whether a company s stock is a good buy understanding relative valuation modelsthere are many different types of relative valuation ratios such as price to free cash flow enterprise value ev operating margin price to cash flow for real estate and price to sales p s for retail 12one of the most popular relative valuation multiples is the price to earnings p e ratio it is calculated by dividing stock price by earnings per share eps and is expressed as a company s share price as a multiple of its earnings a company with a high p e ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued likewise a company with a low p e ratio is trading at a lower price per dollar of eps and is considered undervalued this framework can be carried out with any multiple of price to gauge relative market value therefore if the average p e for an industry is 10x and a particular company in that industry is trading at 5x earnings it is relatively undervalued to its peers 3one of the most common metrics in relative valuation models is the p e or price to earnings ratio this is calculated by dividing a company s stock price by its annual earnings per share relative valuation model vs absolute valuation modelrelative valuation uses multiples averages ratios and benchmarks to determine a firm s value 45 a benchmark may be selected by finding an industry wide average and that average is then used to determine relative value an absolute measure on the other hand makes no external reference to a benchmark or average a company s market capitalization which is the aggregate market value of all of its outstanding shares is expressed as a plain dollar amount and tells you little about its relative value of course with enough absolute valuation measures in hand across several firms relative inferences can be drawn in addition to providing a gauge for relative value the p e ratio allows analysts to back into the price that a stock should be trading at based on its peers for example if the average p e for the specialty retail industry is 20x it means the average price of stock from a company in the industry trades at 20 times its eps assume company a trades for 50 in the market and has an eps of 2 the p e ratio is calculated by dividing 50 by 2 which is 25x this is higher than the industry average of 20x which means company a is overvalued if company a were trading at 20 times its eps the industry average it would be trading at a price of 40 which is the relative value in other words based on the industry average company a is trading at a price that is 10 higher than it should be representing an opportunity to sell because of the importance of developing an accurate benchmark or industry average it is important to only compare companies in the same industry and market capitalization when calculating relative values 