What Is Relative Value?
Let me explain relative value to you directly: it's a way to figure out what an asset is worth by stacking it up against similar ones. This differs from absolute value, which just zeros in on the asset's own inherent worth without any comparisons. You'll often see the price-to-earnings ratio, or P/E ratio, used here to gauge the relative value of stocks.
Key Takeaways
- Relative value evaluates an asset's worth through comparisons with similar assets.
- These methods help you make fair comparisons between potential investments.
- One big downside is that it can trap you into picking the least bad option instead of looking for truly good ones elsewhere.
Understanding Relative Value
As a value investor, I always dive into the financial statements of competing companies before committing my money. You should look at footnotes, management notes, and economic data to judge a stock's value against its peers.
When you're doing relative valuation, start by spotting comparable assets and companies. Check their market caps and revenue numbers—those stock prices show how the market values them right now. Then, pull out price multiples like the P/E or price-to-sales ratio. Finally, compare these across peers to see if your target stock is undervalued compared to others.
Benefits of Relative Valuation
You have to pick from what's actually out there to invest in at any moment, and relative valuation makes that easier. Think about it: in 2019, looking back at 2009 U.S. stock prices shows they were undervalued, but that doesn't help today. That's where something like the stock market cap-to-GDP ratio comes in handy. The World Bank has data on this for many countries over decades. With U.S. stocks at record highs relative to GDP in 2019, stocks in other countries looked relatively cheap.
Criticism of Relative Valuation
The main issue with relative valuation is it can force you to settle for the best in a bad bunch. If you're stuck in one asset class, it might just minimize your losses in tough times. For instance, value funds outperformed the S&P 500 in the 2000-2002 bear market, but most still lost money.
Relative Valuation vs. Intrinsic Valuation
Relative valuation is one of two key ways to value a company; the other is intrinsic valuation. You might know the discounted cash flows (DCF) method for intrinsic value—it projects future free cash flows and discounts them using a required rate to get a present value. If that value beats the investment cost, it could be a solid opportunity.
An Example of Relative Value
Take this comparison of Microsoft with other tech firms. Microsoft has a market cap of $666.154 million, net income of $22.113 million, and a P/E of 30.5. Oracle: $197.500 million cap, $9.913 million income, P/E 20.5. VMware: $52.420 million cap, $1.186 million income, P/E 46.8. From this, Microsoft looks overvalued next to Oracle but undervalued compared to VMware.
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