Valuation Talk | Relative Valuation Methods for Value Assessment

Price-to-Book (P/B) Ratio Method: This method compares a company’s P/B ratio with those of peer companies in the same or related industries. If a company’s P/B ratio is lower than the industry or sector average, it may be considered undervalued. You can also compare a comparable company’s share price with any of its per-share financial metrics to derive a “P/X” ratio (e.g., P/E, P/B), then multiply that P/X ratio by the corresponding per-share metric of the target company to estimate the target’s “fair” share price—against which you compare its current market price to assess whether it is undervalued or overvalued. In practice, the most widely used relative valuation methods are the P/E and P/B approaches. Nearly all brokerage-provided securities analysis and trading platforms calculate and display P/E and P/B ratios. Some even generate industry-level relative valuation range charts, offering an intuitive, at-a-glance view—eliminating the need for manual calculations. See figure below: 02 Advantages of Relative Valuation 1. Relative valuation is a simple and intuitive method, offering insight into whether a company or asset is potentially undervalued or overvalued. 2. By benchmarking against peers in the same or related industries, relative valuation often yields more accurate estimates. 3. It relies primarily on publicly available data—such as market prices, yields, and financial metrics—making data collection relatively straightforward. Applicability of Relative Valuation: 1. Best suited for companies or assets within the same or related industries—commonly applied to equities, bonds, real estate, and other assets traded in public markets. 2. Particularly appropriate for assets characterized by multiple interrelated factors and metrics—for example, stock price, P/B ratio, P/E ratio, etc. 3. Typically used to compare individual companies or assets—not entire markets or sectors. 03 Limitations of Relative Valuation Key multiples used in relative valuation—such as P/E and P/B—have numerators tied directly to the stock’s current market price. As Luo Shu explained in his inaugural WeChat article, “Essays on Investment Philosophy | The Essence of Securities”: A stock embodies two attributes—the “gu” (share/equity), representing intrinsic equity value; and the “piao” (ticket), representing its voting-price function. Wherever a market price exists, there exists a “voting direction.” If most investors believe the price will rise and vote “buy,” the price rises; conversely, if most anticipate a decline and vote “sell,” the price falls. Thus, relative valuation outcomes may be significantly influenced by market sentiment-driven volatility—potentially failing to reflect the company’s true intrinsic value. This is the primary limitation of relative valuation: it may overlook a company’s unique circumstances and distinctive characteristics, leading to inaccurate valuations.

How Do We Actually Assess Whether Valuation Levels Are High or Low?

By Mo Yu / Author of "Old Friend Fund" In everyday conversations, seasoned fund investors frequently say things like, “Fund X is highly valued” or “Fund Y is undervalued.” What exactly do they mean by “overvalued” or “undervalued”? First, we must clarify one key point: valuation applies to stocks—or stock indices—not to funds themselves. So when people refer to a “fund’s valuation level,” they usually mean the valuation level of the underlying stock index held by that fund—especially for passive or enhanced-index funds. For thematic funds, their valuation level may be approximated by referencing the valuation of the relevant theme. For purely actively managed funds, however, it is generally difficult to assign a meaningful valuation level. That said, for actively managed funds with pronounced style biases (e.g., strong growth or value orientation), we can still identify reasonably comparable valuation benchmarks. I. What Exactly Is Valuation? Understanding Key Metrics Valuation is most commonly expressed via the Price-to-Earnings (P/E) ratio. Other common valuation metrics include Price-to-Book (P/B) and Price-to-Sales (P/S). Regardless of the metric, each essentially measures the multiple between a company’s market price and some fundamental indicator of its intrinsic value—such as earnings or book value. Generally speaking, higher P/E or P/B ratios suggest greater overvaluation; lower ratios suggest greater undervaluation. Yet because valuation norms vary significantly across industries, how can we determine whether a given valuation is truly high or low? We can consult the historical percentile ranks of a stock’s P/B and P/E ratios within its respective industry or sector. These percentiles range from 0% to 100%: the higher the percentile rank—i.e., the more elevated the current ratio is relative to its historical distribution—the more overvalued the stock appears; conversely, the lower the percentile, the more undervalued it appears. Valuation is inherently a relative concept—it cannot be assessed in isolation. Typically, we compare an index’s current valuation level against its own historical valuation range to gauge where it stands today. II. Does a High Valuation Automatically Mean “Bad”? Not necessarily. Consider everyday shopping: Is an expensive item always better—or is a cheaper one always superior? Some argue, “Expensive items have their merits; cheap ones must have flaws.” Others counter, “High prices reflect ‘IQ taxes’; low prices offer better value for money.” The same logic applies to valuation. The market rally from 2020 to 2021 largely reflected the “expensive items have merit” narrative, while the market dynamics since the Spring Festival of 2022 have embodied the “cheaper items offer better value” logic.

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