Relative Value

What is 'Relative Value'

Relative value is a method of determining an asset's value 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. Calculations that are used to measure the relative value of stocks include the enterprise value (EV) ratio and price-to-earnings (PE) ratio.

BREAKING DOWN 'Relative Value'

When value investors are considering which stocks to invest in, they do not just look at the financial statements of the companies, in which they are interested. They also look at the financial statements of competing companies -- along with relevant footnotes, management commentary, and industry and economic data --  to assess the stock's value, relative to its peers.

Steps in relative valuation may include:

  • First, identifying comparable assets and/or corporations. In these cases, it can be useful to view market capitalizations and revenue or sales figures. The market values for comparable companies can be viewed as their stock prices -- what the general public has priced them at.

  • Deriving price multiples from these initial figures. Price multiples can include ratios, such as price-to-earnings (PE), price-to-sales (PS), or Value/EBIT.

  • Comparing these multiples across a company’s peer or competitor group to determine an over- or under-valued security.

Example of Relative Value Analysis Results

An example of a relative value analysis results for Microsoft Corporation (MSFT):

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, despite some variations in company sizes, Microsoft is overvalued, relative to Oracle; yet undervalued, relative to VMWare.

Relative v. 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 (above), a DCF model uses a company’s future free cash flow projections and discounts them. This is done, using a required annual rate. Eventually, an analyst will arrive at present value estimate, which can then be used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.