CFA Level I · CFA Level I Exam

Relative Value Equity Valuation Approaches for CFA Level I

Relative valuation estimates a stock's value by comparing its price multiple, such as P/E, P/B, P/S, P/CF or EV/EBITDA, with the multiples of peers, the sector or its own history. To solve questions, pick the right multiple, check comparability, compute the implied value, then judge whether the stock looks cheap or expensive.

What this chapter covers

This chapter covers relative valuation. Instead of discounting cash flows to find intrinsic value, you compare a company's price with a fundamental such as earnings, book value, sales, cash flow or EBITDA. The result is a multiple. You then compare that multiple with a benchmark: peer companies, an industry, a market index or the company's own past.

The chapter moves from the multiples themselves (P/E, P/B, P/S, P/CF) to enterprise value multiples (EV/EBITDA), then to dividend yield and related ideas. It then covers the method of comparables, where you choose peers and benchmarks, and ends with cross-border and industry-specific issues, such as differing accounting standards and sector quirks.

It connects to the rest of the paper in three ways. Financial statement analysis supplies the earnings, book value and cash flow inputs, and the adjustments for quality of earnings. Equity valuation using dividend discount and free cash flow models is the intrinsic counterpart, and you are often asked which approach suits a given company. Corporate finance and capital structure explain why enterprise value is useful when leverage differs.

Equities carry a meaningful share of the Level I paper, and multiples questions are usually short and standalone, which suits the three-option format. Most can be answered in well under the suggested 90 seconds once you know the formulas and the logic. There is no penalty for wrong answers, so even conceptual questions on comparability and limitations are worth attempting. Mastering this chapter also helps your reading of equity analysis questions elsewhere, because the same multiples appear in financial statement analysis and portfolio contexts.

Relative Value Equity Valuation Approaches: topics in the order to study them

1Price Multiples: P/E, P/B, P/S and P/CFThese are the core multiples; every later topic builds on their definitions, drivers and limitations.
2Enterprise Value Multiples (EV/EBITDA)Once price multiples are clear, you see why EV handles differences in leverage and how it is built from market value, debt and cash.
3Dividend Yield and Other Multiples ConceptsThis adds the remaining multiples and the idea of justified multiples, tying relative value back to fundamentals.
4Method of Comparables and BenchmarksWith the multiples known, you learn how to apply them against peers, sectors and history, and how to read the result.
5Cross-Border and Industry-Specific Valuation IssuesThis is last because it refines everything before it: accounting differences, currencies and sector-specific multiples.

How to prepare Relative Value Equity Valuation Approaches

Aim for a clear grasp of definitions first, then speed on calculations, then judgement on which multiple fits a situation.

Write each multiple as a formula with its numerator and denominator on one page, and note whether the numerator is price (equity) or enterprise value.
For each multiple, list three things: what drives it, when it is useful, and its main weakness (for example negative earnings for P/E, or intangible-heavy firms for P/B).
Practise building enterprise value from market capitalisation, debt, preferred stock and cash, and matching it to an operating-level denominator such as EBITDA.
Work small numerical examples using the method of comparables: take a peer average multiple, multiply by the subject's fundamental, and state the implied value.
Drill conceptual questions on comparability: similar growth, risk, size, accounting policies and business mix. Practise eliminating options that ignore these.
Review how accounting differences and industry features distort multiples, and which multiple each industry tends to favour.
Finish with timed mixed sets of three-option questions. Review every miss and tag it as a formula, concept or reading error.

Common mistakes in Relative Value Equity Valuation Approaches

Using equity value with an operating measure, or EV with a per-share equity measure
Fix: Before computing, ask whether the denominator belongs to all capital providers or only shareholders, and choose price or EV accordingly.
Forgetting to subtract cash when computing enterprise value
Fix: Memorise the full EV line: equity + debt + preferred − cash and short-term investments, and write it out at the start of each question.
Declaring a stock undervalued just because its multiple is below the peer average
Fix: Always check whether growth, risk and accounting justify the gap. The multiple difference may be deserved.
Applying P/E to a company with negative or erratic earnings
Fix: Recognise the limitation and look for the alternative, such as P/S, EV/EBITDA or P/B, that fits the situation.
Mixing trailing and forward figures between the subject company and its peers
Fix: State the basis for each multiple and make sure subject and benchmark use the same one.
Ignoring accounting and cross-border differences when comparing firms
Fix: Check for different accounting standards, policies and country risk, and note that adjustments are needed before comparing.

Last-day revision: Relative Value Equity Valuation Approaches

P/E = price per share ÷ earnings per share; it is not meaningful when earnings are negative.
P/B = price per share ÷ book value per share; useful for asset-heavy firms such as financial institutions, weaker for intangible-heavy ones.
P/S = price per share ÷ sales per share; usable when earnings are negative but ignores profitability.
P/CF is less easily manipulated than earnings but depends on which cash flow measure is used.
EV = market value of equity + market value of debt + preferred stock − cash and short-term investments.
EV/EBITDA is useful when comparing firms with different leverage, and it is unaffected by depreciation policy differences.
Match numerator and denominator: equity-based price with per-share equity measures, EV with operating measures before payments to capital providers.
Method of comparables assumes similar companies should trade at similar multiples; check growth, risk and accounting.
Trailing multiples use past fundamentals; forward multiples use forecasts and are only as reliable as the forecast.
Differences in accounting standards, currencies and country risk can make cross-border multiples non-comparable.
A low multiple alone does not prove undervaluation; there may be lower growth or higher risk.
Quickly eliminate options that confuse equity value with enterprise value.

Relative Value Equity Valuation Approaches practice questions

Relative Value Equity Valuation Approaches in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Relative Value Equity Valuation Approaches: frequently asked questions

What is relative valuation in equity analysis?

Relative valuation values a stock by comparing its multiple, such as P/E or EV/EBITDA, with a benchmark like peers, the industry or its own history. It does not estimate intrinsic value directly. It tells you whether a stock looks expensive or cheap compared with others.

When should I use EV/EBITDA instead of P/E?

EV/EBITDA is useful when companies have different capital structures, because EV includes debt and the denominator is measured before interest. It also helps when earnings are negative or affected by depreciation policy. P/E is more direct for equity holders when earnings are stable and positive.

Do I need a calculator for this chapter?

Most calculations are simple multiplication and division, so you can do them with the approved TI BA II Plus or HP 12C in a few seconds. The harder part is choosing the right multiple and the right inputs. Practise setting up the calculation before pressing keys.

How should I study this chapter alongside a job?

Study one topic per session in the suggested order and finish each with a short set of questions. Use phone-friendly notes for formulas and limitations during breaks. Keep longer sessions for timed mixed practice.