Discovering The Power of Relative Value in Investments
Relative value is a method for determining an asset’s worth by considering the value of similar assets. Unlike absolute value, which focuses solely on an asset’s intrinsic value, relative value allows for effective comparison across multiple assets. The price-to-earnings ratio (P/E ratio) is a popular method to gauge the relative value of stocks.
Key Takeaways
- Relative value assesses an asset’s worth relative to similar assets.
- This method enables investors and analysts to make better comparison-based evaluations across potential investments.
- A drawback of relative valuation is that it might compel investors to pick the best option among less favorable choices.
Gaining Insight with Relative Valuation
Value investors scrutinize financial statements of competing companies before deciding where to place their investments. They review footnotes, management commentary, and economic data to determine a stock’s value in comparison to its peers.
Steps in relative valuation typically include:
- Identifying comparable assets and companies: Consider market capitalizations and revenue or sales figures. Stock prices reveal how the market values similar firms at a given time.
- Calculating price multiples: These include ratios like the P/E ratio or the price-to-sales ratio (P/S ratio).
- Comparing multiples across a peer group: This helps determine if a company’s stock is undervalued relative to others.
The Advantages of Relative Valuation
Investors tend to select from the investments available at a given moment, and relative valuation aids this process. For example, it was evident by 2019 that most U.S. stocks in 2009 were undervalued. However, this historical insight doesn’t guide current investment decisions. This is where relative valuation, like the stock market capitalization-to-GDP ratio, becomes invaluable. If U.S. stocks are near record highs in terms of market capitalization to GDP, stocks in other countries might appear relatively inexpensive.
Addressing Criticism of Relative Valuation
One notable downside of relative valuation is it might force investors to choose the least poor option. Within a single asset class, this method may only minimize losses in adverse conditions. For instance, during the 2000-2002 bear market, value funds often outperformed the S&P 500 but still incurred losses.
Comparing Relative Valuation and Intrinsic Valuation
Relative valuation is one of two pivotal methods for valuing a company; the other is intrinsic valuation. The Discounted Cash Flows (DCF) method is widely recognized among intrinsic valuation techniques. While relative valuation uses various multiples, the DCF model involves a company’s future cash flow projections, discounted at a required annual rate to reach a present value estimate. If this value exceeds the investment cost, it could represent a worthwhile opportunity.
A Practical Example of Relative Value
Consider the following table comparing financial information of leading tech 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 |
From this analysis, Microsoft appears overvalued relative to Oracle but undervalued compared to VMware.
Related Terms: absolute value, intrinsic value, P/E ratio, price-to-sales ratio, financial statements.
References
- The World Bank. “Market Capitalization of Listed Domestic Companies (% of GDP)”.
