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*(Please note the flair: basics / Getting started)*
This is a post on how to do relative valuation of companies. This is one of the two broad methods of valuing companies.
Although this is not popular these days with the finance crowd, it is used more often than you think.
Every time we compare prices or metrics like Price per square foot, we are using relative valuation to compare an asset to what it was historically ( eg “the average 10 year p/e of this company around 18”) or against its peers presently (eg, “the p/e of the SAAS companies are on average 25”) or historically (eg. “ the aerospace industry sells on average at 31 times forward p/e historically”)
**Mean Reversion.**
The fundamental reason for relative valuation is the term **mean reversion**. “Mean reversion” means that things that used to be sold at a certain range, eg. an average p/e of 18-20 will occur again even if the stock is temporarily selling at 15 or at 25.
When Benjamin Graham was asked by congress on the nature of price fluctuations and when mean reversion will occur and whether it is possible to time it, he replied that no one really knows when it would revert in the short term.
**Ratios that matter**
It is important to use ratios appropriately. Every ratio has its fans and detractors, because no ratio is perfect. You are probably familiar with these below, and I will give you my comments on them:
**P/E ratio. (Price to earnings ratio)** This has many variations so it is important not to mix and match from different sources. Even Morningstar which I use has a few variations including trailing 12 month P/E, forward p/e, normalised P/E.
Buffett (or Buffett approved purchases at Berkshire) likes to buy stuff at forward p/e of 15 or 16. This would include Apple, Pilot (trucking), and Google at a fwd p/e of 17 to 19.
However sometimes the earnings is lumpy or negative, or there simply isn't enough numbers to form a historical average. Then the solution would be to use a **P/S Ratio (Price to Sales Ratio)**. This is a great ratio for handling fast growers, especially small to mid-size companies where they are at a growth cycle and profits earned are being ploughed back into the business to grow sales.
The P/S ratio has fallen into disused because post the Bubble-Burst of 2001, there were many companies who were never ever going to make a profit despite impressive sales, and they were valued on P/S.
The two metric are the **P/B ratio (Price to Book Value Ratio)** and **EV/EBITDA**. Price to Book doesn't work so well on modern companies becasue of the asset light nature of the business, however this is a great metric for valuing banks, insurance and other financial companies which depend on the balance sheet for its primary business. We can still use P/B as a approximation for valuing Berkshire Hathaway, it's stock holdings of AXP, MCO, AAPL, GOOGL etc are marked at market prices on its balance sheet. EV/EBITDA is a great metric and is considered cleaner than the P/E ratio, because it takes into consideration debt. The downside of using this metric is the extra steps needs to calculate this metric.
**Relative to what ?**
You can use the above ratios and compare it with:
\- Historical averages (typically 5 or 10 years)
\- The industry peers current ratios
\- The industry historical average
**Some Caveats to note before we work on an example**
\- There is a great deal of subjectivity when dealing with relative valuation, when in doubt, be conservative .
\- Just because a stock is cheap with relative valuation does not mean it is a buy. Western Union (WU) hovered with a P/E in the teens for years but it has currently a P/E of 4.5 with a five year average of 6. Does it mean it will revert back to a P/E of 6 ? or go back up to the teens ? My answer is No unless they can solve the current issue of decling growth and shrinking margins.
\- If valuations are currently elevated, then comparing a stock to its peers will result in an expensive stock because the peers are richly valued. The converse is also true.
**A simple example with Amazon dot com**
Six years after IPO did Amazon reach GAAP profitability. And even after that Amzn prioritised sales growth over profitability. The primary way which Amazon was valued then was Price to Sales (P/S) ratio. Fast forward to 2026, and sales is slowing down, but operating margins have improved from 2-3% in 2016 /2017 to 10/11% in 2024/2025. I wanted to find out I could still use P/S as a relative valuation on Amazon.
Step one: Work out the price / sales for the last 10 years
2016-> 2.83, 3.56, 3.39, 3.50, 4.76, 3.74, 1.71, 2.85, 3.78,3.61 <- 2025
Removing 1.71 and 4.76 as possible outliers
2016-> 2.83, 3.56, 3.39, 3.50, 3.74, 2.85, 3.78,3.61 <- 2025
Average P/S = 3.408
Step two: work out the current Sales per share
2025 Full year sales = 716.92 billion
Current shares outstanding = 10.69 billion
Sales per share = 716.92 / 10.69 = 716.92 / 10.69 = 67.1
Step three: work out the implied share price given the average P/S ratio and Sales per share
Price / Sales = 3.408
Price = 3.408 x Sales = 3.408 x 67.1 = $228.68
The implied value of Amazon is around $228.68
Current morningstar fair price is around 260
Current CFRA's fair value price is 227.22
When i did my usual paper value using earnings, my range of fair value was 207 to 229.
**A more interesting example with Reddit (RDDT)**
Reddit does not have a lot of metrics since it IPO'ed only in 2024, so we can't use the example of amazon and apply an average P/S ratio for RDDT. A more appropriate comparison would be to compare Reddit with Meta, and to make it a more apples to apples comparson, we should use META's first five years since IPO and measure the average P/S and see if we can apply it to Reddit.
During Meta's first five years of IPO, this was their P/S range
|Year|P/S Ratio Range (Low - High)|
|:-|:-|
|2012 (IPO)|9.5x — 18.5x|
|2013|10.1x — 19.8x|
|2014|16.4x — 22.0x|
|2015|15.7x — 18.5x|
|2016|12.1x — 16.5x|
|2017|12.7x — 15.5x|
Now to be fair, Meta grew at 50% year on year. But what about Reddit ?
Here are the future 5 year sales projections for Reddit:
MS-NR, 2025->2,202m 3,265m 4,311m 5,389m 6,602m 7,922m <- End 2030
SAcom, 2025-> 2.20B, 3.13B, 4.05B, 5.18B, 6.30B, 7.98B <- End 2030
The CAGR works out to 29.39%
So far we are trying to find out what is a good P/S ratio from Meta that is applicable to Reddit. While it is tempting to use Meta's high P/S of 18 to 22x for Reddit, Reddit's growth is less than Meta's (29.39 vs 50%). So perhaps to be prudent, i will use a 15x and apply to Reddit.
Price / sales per share = Price / 11.53 = 15
then implied fair value of RDDT = 15 x 11.53 = **172.95**
(When i tried to do a cash flow based analysis on Reddit, i found the earnings growth rates to be very wide as there is no long term track record. The average consensus growth estimates for the 5 years is 36.17% CAGR. The implied fair value is $163.68 and slightly lower than the above, because the company is emphasizing sales over profits)
One piece of info is that despite the pessimisim of AI stocks and Reddit, the current P/S is 12.12. So we know that perhaps during this growth period the flow is around the P/S of 12.12
**Bonus question:** If RDDT sales grows at 29.39% a year and reach 7.98B by end 2030. What is the potential share price in five year time, and what is the annual share price appreciation one can expect if you were to buy it at the current price of $140 ?
Step 1: calculate the shares outstanding by 2030.
Management has stated that share price dilution will be 1 to 3% a year.
(202m) x (1.015)\^5 = approx 217 million.
Sales is 7980 million, sales per share = 7980/217 = $36.8 by 2030.
Step 2: calculate the implied share price by end of 2030
Price / Sales = 15
Price = 36.8 x 15 = $551.6
Step 3: Calculate the annual share price appreciation if you were to buy at today's price of $140
CAGR = (551.6/140)\^(1/5) -1 = 31.55%
The annualised return is around 31.55%
===
**WORST** case scenario:
The P/S stays at the current 12.12, then price = 12.12 x 36.8 = $446.016
CAGR = ( 446 / 140) \^ (1/5) -1 = 26.07%
FIN .