Relative Valuation Models.

While researching Smithson Genomics, Inc., STH HI)’^ in the Healthcare Information Services industry, you encounter a difference of opinions. One analyst’s report claims that STHI is at least 15 percent overvalued, based on a comparison of its PIE with the median PIE of peer companies in the Healthcare Information Services industry and taking account of company and peer group fundamentals. A second analyst asserts that Srnithson is undervalued by 10 percent, based on a comparison of STHI’s PIE with the median PIE of the Russell 3000 Index, a broad-based U.S. equity index. Both analyses appear to be carefully executed and reported. Can both analysts be right? Yes.

The assertions of both analysts concern relative valuations. The first analyst claims that STHI is relatively overvalued compared with its peers (in the sense of the purchase cost of a unit of earnings, PIE). Suppose that the entire Healthcare Information Services industry is substantially undervalued in relation to the overall market as represented by the Russell 3000. STHI could then also be relatively undervalued relative to the Russell 3000. Both analysts can be right because they are making relative valuations. Analysts ultimately care about the investment implications of their information. If the second analyst believes that the market price of the Russell 3000 fairly represents that index’s intrinsic value, then she might expect a positive alpha from investing in STHI, even if some other peer group companies possibly command higher expected alphas. In practice, the analyst may consider other factors such as market liquidity in relation to the intended position size. On the other hand, if the analyst thought that the overall market valuation was high, the analyst might anticipate a negative alpha from investing in STHI. Relative valuation is tied to relative performance. The analyst in many cases may want to supplement such information with estimates of intrinsic value.