Relative valuation is a method used to assess the value of an asset by comparing it to the values of similar assets in the market. This approach relies on market multiples derived from comparable companies or transactions, such as price-to-earnings (P/E) ratios, enterprise value-to-EBITDA (EV/EBITDA), and price-to-book (P/B) ratios.
Let's say we are valuing a tech startup, XYZ Tech, which has earnings of $5 million. We identify three comparable companies in the tech industry with the following P/E ratios:
To calculate the relative valuation, we can use the average P/E ratio of the comparable companies:
Average P/E= (20+25+22)/3 = 22.33
Next, we apply this average P/E ratio to XYZ Tech's earnings:
XYZ Tech had earnings of $5 million and the average P/E ratio of comparable companies is 22.33, the estimated value of XYZ Tech would be $111.65 million, providing a market-based valuation benchmark.
Estimated Value of XYZ Tech=22.33×$5 million=$111.65 million
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