Relative Value

What Is Relative Value?

Relative value is a method of determining an asset's worth that takes into account the value of similar assets. This is in contrast with absolute value, which looks just at an asset's intrinsic value and does not compare it to other assets. The price-to-earnings ratio (P/E ratio) is a popular valuation method that can be used to measure the relative value of stocks.

Understanding Relative Value

Value investors examine the financial statements of competing companies before deciding where to invest their money. They take a gander at relevant footnotes, management commentary, and economic data to assess the stock's value relative to its peers.

Steps in relative valuation might include:

• First, identifying comparable assets and corporations. In these cases, it very well may be useful to view market capitalizations and revenue or sales figures. Their stock prices represent how the market values comparable companies at some random time.
• Deriving price multiples from these initial figures. Price multiples can include ratios, such as the P/E ratio or the price-to-sales ratio (P/S ratio).
• Comparing these multiples across a company's peer or competitor group to determine on the off chance that the company's stock is undervalued relative to other firms.

Benefits of Relative Valuation

Investors must always choose among the investments that are really available at some random time, and relative valuation helps them to do that. By 2019, it was easy to glance back at the prices of most U.S. stocks in 2009 and realize that they were undervalued. However, that does not help one to choose better investments today. That is where a relative valuation method like the stock market capitalization-to-GDP ratio shines. The World Bank maintains data on stock market capitalization as a percentage of GDP for some nations covering several decades. With U.S. stocks near record highs in terms of stock market capitalization as a percentage of GDP in 2019, stocks in most other countries were relatively inexpensive.

Investors must always choose among the investments that are really available at some random time, and relative valuation helps them to do that.

Criticism of Relative Valuation

The primary flaw of relative valuation is that it might condemn investors to making the best of a terrible situation. When limited to a single asset class, relative valuation can do little more than reduce losses in extreme circumstances. For example, value funds generally showed improvement over the S&P 500 during the 2000-2002 bear market. Unfortunately, most of them still lost money.

Relative Valuation vs. Intrinsic Valuation

Relative valuation is one of two important methods of placing a monetary value on a company; the other is intrinsic valuation. Investors may be know all about the Discounted Cash Flows (DCF) method for determining the intrinsic value of a company. While relative valuation incorporates numerous multiples, a DCF model uses a company's future free cash flow projections and discounts them. That is achieved by using a required annual rate. Eventually, an analyst will arrive at a present value estimate, which can then be used to evaluate the potential for investment. On the off chance that the DCF value is higher than the cost of the investment, the opportunity might be a decent one.

An Example of Relative Value

Consider the accompanying table of financial data comparing Microsoft to other technology firms.

Highlights

• Relative value looks at an asset's worth by comparing it with the value of similar assets.
• Relative value methods permit investors and analysts to make better apples-to-apples comparisons across potential investments.
• One major flaw in using relative valuation is that it might pigeonhole investors to select the best among poor or mediocre choices rather than searching elsewhere.