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 only 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.

Key Takeaways

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

Understanding Relative Value

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

Steps in relative valuation may include:

  • First, identifying comparable assets and corporations. In these cases, it can be useful to view market capitalizations and revenue or sales figures. Their stock prices represent how the market values comparable companies at any given 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 if the company's stock is undervalued relative to other firms.

Benefits of Relative Valuation

Investors must always choose among the investments that are actually available at any given time, and relative valuation helps them to do that. By 2019, it was easy to look 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 many 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 actually available at any given time, and relative valuation helps them to do that.

Criticism of Relative Valuation

The primary flaw of relative valuation is that it may condemn investors to making the best of a bad 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 did much better than 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 might be familiar with the Discounted Cash Flows (DCF) method for determining the intrinsic value of a company. While relative valuation incorporates many 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. If the DCF value is higher than the cost of the investment, the opportunity may be a good one.

An Example of Relative Value

Consider the following table of financial information comparing Microsoft to other technology firms.

Company

Market Capitalization (millions)

Net Income (millions)

Price-to-earnings (PE) ratio

Microsoft

$666.154

$22.113

30.5

Oracle

$197.500

$9.913

20.5

VMware

$52.420

$1.186

46.8

Based on the above relative value analysis results, Microsoft is overvalued relative to Oracle. However, Microsoft is also undervalued relative to VMware.