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# Finding True Value: Relative Valuation

Stock valuation is a topic that stumps many beginning investors -- and a fair number of veterans, too. I'd like to shed some light on the idea of putting a price tag on complex and abstract objects, like publicly traded companies, by going through the process along with you at home.

My main test subject for this miniseries will be semiconductor veteran Texas Instruments (NYSE: TXN  ) , so break out your trusty-rusty reverse Polish calculator. It's just for decoration today, but you'll need it in the next two parts.

Peer-valuation ratios
Let's start with the easy numbers for a quick warm-up. The quick-and-dirty practice of comparing your target company with a peer group, lifting the competition's valuation ratios, and applying them to the object under study is called relative valuation. It's appealing for a few reasons.

First, it's a fast and simple method that doesn't take more number-crunching than a couple of simple divisions. Second, the idea makes some intuitive sense -- why should we pay more for every dollar earned by company A, compared with company B? Third, and this is the insidious part, many media pundits talk up these metrics (but mostly just the P/E ratio) as though they were your infallible guides to instant riches.

So let's take this approach to Texas Instruments, then. Here's a quick look at the company's current valuation ratios, and those of the competition:

Company

P/E

Price/Book

Price/Free Cash Flow

EV/EBIT

Texas Instruments

11.6

4.2

42.3

13.8

QUALCOMM (Nasdaq: QCOM  )

38.1

5.0

34.6

20.7

STMicroelectronics NV (NYSE: STM  )

35.3

1.8

47.6

22.6

National Semiconductor (NYSE: NSM  )

19.9

4.6

23.1

10.1

31.6

3.7

44.4

15.2

Peer group average

31.1

3.8

35.1

17.8

Source: Capital IQ, a division of Standard & Poor's.

As you can see, it's a mixed bag. Texas Instruments looks richly valued compared next its peers if you focus on price-to-book or price-to-free cash flow ratios, but less so when looking at P/E and enterprise value to EBIT (earnings before interest and taxes, otherwise known as operating earnings). Applying the average ratios to Texas Instruments makes it look anywhere between 13% overvalued and 183% undervalued. How do you know which of these ratios is the closest to a true value? Do any of them qualify?

The trick here is that none of these companies is Texas Instruments. They all have different operating philosophies and various levels of success, and while the Dallas-based chip maker generates gobs of net and operating income, its cash-flow creation skills aren't quite as impressive -- which should send up warning flags for any Fool worth his or her salt. The bottom line is that you'd better know what makes each of these companies tick before you try to fit their valuation tiaras on one another.

Historical ratios
OK, so how about comparing today's valuation with ghosts of Christmases past? Capital IQ can show me the company's average ratios over the past seven years, so let's have a stab at that approach instead.

Like nearly every other tech stock on the market, this one was seriously expensive back in 2000 and 2001, but it came crashing down as the tech bubble popped with a big, wet thud. Counting back to 2002, then, I won't test your patience with another dull table. Just know that Texas Instruments' average P/E ratio over the past five years has been about 45; the price/book around 3.6; price to free cash flow, 30 or so; and EV to EBIT a whopping 50.

The trends outlined for the peer comparison repeat themselves, only in stronger force. It turns out that Texas Instruments would be worth four times today's price if it got back to its five-year average P/E ratio of about 45, and nearly as much at an enterprise value of 50 times operating earnings. Yowza. But the other two metrics remain on the somewhat overvalued side of reasonable.

It's all very interesting, and the discrepancy between earnings and cash flow growth is worthy of further study, but we're no closer to a true value than when we began. A relative valuation, after all, compares our company only with its peers; the entire group could be wildly over- or undervalued.

That's great, but ...
It all means that a relative valuation doesn't make complete sense in the case of Texas Instruments, whether you're attempting to compare it with a peer group or to the company's own history. The business is simply changing too quickly for such a simplistic tool to keep up, and you could argue that TI's flexible, partly outsourced manufacturing model and market-leading net margins -- among other items -- puts it in another league compared with the competition.

Valuation ratios such as the P/E and EV/EBIT metrics aren't completely useless, as they can give you a feel for a company's value, compared with this, that, or the other. But you'd be hard pressed to find a situation where it can give you a complete picture. No company is surrounded by an army of cloned competitors, nor do business conditions tend to stay stable for very long.

But there are other valuation tools out there. Next up, we'll see whether the venerable dividend discount tool might fit the bill here.

Further Foolishness:

See what other investors are saying about the stocks you follow by checking out Motley Fool CAPS. More than 23,000 are chiming in, and you can, too. Participation is free!

Fool contributor Anders Bylund holds no position in any of the companies discussed here, but he does own a TI-30 Stat from his high school days. It still works, and it's even running on its original battery. You can check out Anders' holdings if you like, and Foolish disclosure is always worth a read.

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

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DocumentId: 535465, ~/Articles/ArticleHandler.aspx, 7/6/2015 8:49:45 PM

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Anders Bylund
TMFZahrim

Anders Bylund is a Foolish Technology and Entertainment Specialist. Where the two markets intersect, you'll find his wheelhouse. He has been an official Fool since 2006 but a jester all his life. Right?

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