Stock Valuation Made Simple: A Guide to Relative Valuation

If you're a stock picker who loves valuation, you already know there's a formula-based way to buy stocks. But here's the thing — there are actually two main approaches to valuing a company: relative valuation and cash flow valuation. And while both have their merits, about 95% of the Pakistani market runs on relative valuation ratios. So let's dig into that approach and see how you can put it to work.

The Two Ways to Value a Stock

Before we dive into the numbers, let's set the stage. When you pick a stock, you can value it in one of two ways:

1. Relative valuation — comparing a company's ratios to its peers or the broader market.
2. Cash flow valuation — discounting the company's projected future cash flows back to today's value.

Both work, but because of time constraints and how the market actually behaves, relative valuation is the dominant method — especially in Pakistan. So that's where we'll focus.

What Exactly Is Relative Valuation?

Relative valuation isn't about comparing raw stock prices directly, and it's not about comparing earnings in absolute terms either. Instead, you're comparing ratios between comparable companies.

Think of it this way: a stock priced at 500 rupees might seem expensive next to one priced at 50 rupees — but that tells you nothing without context. What matters is the multiple — like the price-to-earnings (PE) ratio — and how that multiple stacks up against similar companies or the market average.

The PE Ratio: Your Core Valuation Tool

The PE ratio is where all the action happens. Here's the core idea:

Once you know a company's earnings, you multiply those earnings by the average PE multiple that the market typically assigns to similar companies. That gives you a fair value for the stock.

The Formula

Here's how you calculate it step by step:

1. Take the company's earnings.
2. Multiply those earnings by the running average PE multiple for the sector or market.
3. That gives you the fair value.
4. Divide the fair value by the current market price, then subtract 1 to get the percentage upside or downside.

If you want to be more forward-looking, you can use forecasted earnings instead of trailing earnings — that's perfectly valid too, and often more useful if you believe the company's growth is going to accelerate.

Trailing PE vs. Forward PE

One important distinction: a trailing PE is based on the last reported earnings — the actual results the company already delivered. That's your starting point. But for a more complete picture, you'll want to consider forecasted earnings, which factor in expected future performance — especially if the company is growing faster than the market.

Real-World Examples: Putting the Math to Work

Let's walk through some practical examples to show you how this plays out.

Example 1: The Pharmaceutical Sector

Take the pharmaceutical industry. On average, pharmaceutical companies in the market trade at a PE multiple of about 17.3 times. If we use that market average as our benchmark, we can start evaluating individual pharma stocks against it.

If a particular pharma company's earnings are, say, 10 rupees per share, then:

• Fair value = 10 × 17.3 = 173 rupees per share
• Compare that to the current market price to see whether you're looking at an upside or a downside

That percentage difference tells you how much room the stock has — or how overvalued it might be.

Example 2: A Company Below the Market Multiple

Now let's look at another scenario. Suppose you find a company trading at a PE multiple of 8.3 times — or even 8.8 times — while the overall market is trading at around 3.5 times.

Wait — that doesn't sound right. If the market is at 3.5 and the company is at 8.3, the company is actually at a premium relative to the market. That's a situation where the market is paying more for this company's earnings — a multiple of, say, 6 times the market's 3.5. In that case, you need to ask yourself: does this company deserve that premium?

If the company has superior market growth prospects, a strong market share, or is in a sector the market favors, then yes, a higher multiple can be justified. But if not, you might be looking at an overvalued stock.

When a Premium Makes Sense

This is where judgment comes in. A company that trades at a premium multiple isn't automatically a bad buy. You need to compare it to its peers and the broader market context:

• Is it growing faster than the market?
• Does it hold a dominant market share?
• Is it in a sector with structural tailwinds?

If you can answer yes to those questions, the premium might be fully justified. The key is to be able to articulate why the premium exists — not just blindly compare numbers.

Final Thoughts

Relative valuation is elegant in its simplicity: compare ratios, not raw prices, and you'll quickly develop a sense for whether a stock is cheap or expensive relative to its peers. Start with the PE multiple, factor in the sector's running average, and you'll have a tentative valuation for just about any stock in the market.

Now, if you want to go deeper — I'm planning to launch a full course on stock picking with proper valuation techniques, including cash flow valuation for those who want to go beyond relative ratios. I'll be back with more details on that soon, and by the end of it, you'll be able to update and refine your stock-picking process like a pro.

Stay tuned — and happy picking!