How can you adjust for differences in accounting methods when using relative valuation methods?

1 Depreciation method

One of the most common accounting choices that can affect the relative valuation ratios is the depreciation method. Depreciation is the process of allocating the cost of a fixed asset over its useful life. Different depreciation methods, such as straight-line, declining balance, or units of production, can result in different depreciation expenses and book values of fixed assets. This can affect the earnings, book value, and cash flow of a company, and consequently, its P/E, P/B, and P/CF ratios. To adjust for this difference, you can use the same depreciation method for all the companies that you are comparing, or you can add back the depreciation expense to the earnings and book value of the companies that use a more accelerated depreciation method.

2 Inventory valuation method

Another accounting choice that can affect the relative valuation ratios is the inventory valuation method. Inventory is the stock of goods that a company has on hand for sale or production. Different inventory valuation methods, such as FIFO (first-in, first-out), LIFO (last-in, first-out), or weighted average cost, can result in different inventory costs and values. This can affect the cost of goods sold, gross profit, and inventory value of a company, and consequently, its P/E, P/S, and P/B ratios. To adjust for this difference, you can use the same inventory valuation method for all the companies that you are comparing, or you can convert the inventory value and cost of goods sold of the companies that use LIFO to FIFO using the LIFO reserve information provided in the financial statements.

3 Revenue recognition method

A third accounting choice that can affect the relative valuation ratios is the revenue recognition method. Revenue recognition is the process of recording the sales and income of a company when they are earned, not when they are received. Different revenue recognition methods, such as accrual, cash, or percentage-of-completion, can result in different timing and amount of revenue and income. This can affect the sales, earnings, and receivables of a company, and consequently, its P/E, P/S, and P/R ratios. To adjust for this difference, you can use the same revenue recognition method for all the companies that you are comparing, or you can adjust the revenue and income of the companies that use a more aggressive or conservative method using the information on deferred revenue, unbilled revenue, or contract assets and liabilities provided in the financial statements.

4 Other adjustments

Besides the accounting choices mentioned above, there are other factors that can affect the relative valuation ratios, such as the capital structure, the growth rate, the dividend policy, or the industry characteristics of the companies that you are comparing. To adjust for these factors, you can use different approaches, such as using unlevered ratios that exclude the effect of debt, using forward-looking ratios that incorporate the expected growth rate, using dividend-adjusted ratios that account for the payout policy, or using industry-specific ratios that reflect the unique features of the business. The choice of the adjustment method depends on the purpose and context of your relative valuation analysis.

Relative valuation methods are useful tools to compare the value of different companies, but they require careful adjustments for the differences in accounting methods and other factors that can affect the financial ratios. By making these adjustments, you can improve the comparability and accuracy of your relative valuation analysis and make better investment decisions.

5 Here’s what else to consider

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