What Does Relative Value Mean?

A technique called relative value compares an asset to other similar assets and takes into account their valuations in order to determine the asset's value. Unlike absolute value, which focuses solely on the intrinsic asset’s value without considering comparisons, relative value considers the context of analogous assets in the market.

Relative value provides a framework for investors and analysts to effectively compare several possible investments. Value investors consider the financial statements, footnotes, management commentary, and economic data of competing companies to evaluate relative worth of a stock to its competitors.

What are the Advantages of Relative Value?

The advantages of relative value can be summarised as follows:

Apples-to-Apples Comparison: Investors and researchers can more effectively compare various possible assets using relative value approaches. By contrasting an asset's worth with those of comparable ones on the market, relative value analysis provides a context for evaluating the worth of an asset.

Ease of Analysis: Relative valuation methods are generally easier and less time-consuming to perform compared to intrinsic valuation methods. This is especially valuable when dealing with limited financial data or when valuing private companies.

Market-Based Insights: Relative valuation considers the perception of the market of an asset's value. By contrasting an asset with its competitors or industry averages, relative value analysis provides insights on how similar assets are valued in the market. This can help investors identify potential opportunities for investment.

Sanity Check for Intrinsic Valuation: Relative valuation can serve as a "sanity check" for intrinsic valuation methods such as discounted cash flow (DCF) analysis. 

By comparing the results of both methods, investors can gain a more comprehensive understanding of an asset's value and assess the reasonableness of their valuation estimates.

What are the Disadvantages of Relative Value?

It is important to note that although relative value analysis provides valuable insights, it also has limitations. The disadvantages of relative value include the following ones:

Pigeonholing Investors: Relative valuation is a significant drawback in that it may force investors to make the best choice among subpar or average options rather than exploring other investment options. Relative value approaches don't guarantee that the available choices are of high quality or meet their investment objectives.

Imperfect Comparison: Relative valuation relies on contrasting an asset with a collection of analogous assets, known as a "peer group." However, finding an exact match in terms of risk/return profiles and fundamental traits can be challenging. Even if there are publicly traded competitors with similar characteristics, the comparison is still imperfect. The accuracy of relative valuation depends on selecting the right peer group, which may introduce subjectivity and potential biases.

Reliance on Market Assumptions: Relative valuation assumes that the market is correct or provides useful guidelines for valuing a company. It leans on the belief that market prices reflect accurate assessments of an asset's value. However, this assumption may not always hold true, as markets can be influenced by various factors, including investor sentiment, market volatility, and external events. Relying solely on market prices for valuation can introduce risks and potential inaccuracies.

Limited Financial Data for Private Companies: Relative valuation methods, like comparable company analysis, require financial data, which may be limited or unavailable for private companies. Publicly traded companies tend to have more financial information accessible to investors, making relative valuation more challenging for private companies.

Lack of Consideration for Intrinsic Value: Relative valuation focuses on contrasting an asset with analogous assets based on market prices and multiples. It doesn't directly consider the intrinsic asset’s value, such as future cash flows and margins. As to intrinsic valuation, its methods like DCF take into account the fundamental aspects of a firm. Relying solely on relative valuation can overlook significant factors that impact the intrinsic value of an asset.

How to Measure Relative Value?

To measure relative value, several steps are involved. The first one is determining comparable assets and companies. This involves considering factors like market capitalisations and revenue or sales data, which reflect the current market valuation of similar businesses. 

Then, investors and analysts can use various valuation multiples or ratios. Some commonly used ratios involve the price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, price-to-cash flow ratio, and enterprise value (EV). They bring insights into the market value of a company's stock compared to other companies or industry averages. For example, a company with a high P/E ratio may be considered overvalued, while a company with a low P/E ratio may be considered undervalued.

The Example of Relative Value

Let's consider an example to illustrate the concept of relative value. Suppose there are three companies in the same industry: Company A, Company B, and Company C. Company A has a P/E ratio of 15, Company B has a P/E ratio of 20, and Company C has a P/E ratio of 10. Based on the P/E ratio, we can infer that Company C is relatively undervalued compared to its peers because it has a lower P/E ratio. Investors may perceive it as an attractive investment opportunity.

Relative Value contra Intrinsic Value

Relative Value and Intrinsic Value are two different approaches used to determine the worth or value of an asset. 

The idea of intrinsic value is calculating an asset's value based on its cash flows, potential for growth, and risk. In this approach, the value is determined by discounting the expected future cash flows of the asset back to the present using a discount rate that reflects the riskiness of those cash flows. The DCF method is commonly used to estimate intrinsic value. The basic presumption is that an asset's value is determined by its predicted cash flows rather than by subjective judgments. Assets with higher and more predictable cash flows are expected to have higher values than assets with lower and more volatile cash flows. Although it is impossible to know an asset's true intrinsic value, it would be established by an all-knowing analyst given access to all relevant information and a perfect valuation model.

Relative Value is a method of determining an asset's worth by comparing it with the value of similar assets. Instead of depending exclusively on the asset's intrinsic worth, it considers the value of related assets. This approach allows investors and analysts to assess the relative attractiveness of an asset compared to others in the same category. 

Intrinsic Value focuses on the fundamental characteristics and expected cash flows of an asset to estimate its value, while Relative Value compares an asset's value with that of similar assets to assess its relative attractiveness.

Bottom Line and Key Takeaways

By comparing the value of an asset to other assets in the market that are similar, relative value research enables investors and analysts to make wise investment decisions. It helps identify potentially undervalued or overvalued assets and provides a broader perspective on an asset's worth compared to absolute value analysis. However, it is important to recognise that relative valuation has limitations, and investors should consider multiple factors and perform comprehensive due diligence before making investment decisions.

FAQ

1. What is the difference between relative valuation and absolute valuation?

Relative valuation compares a company's value to that of its competitors or industry peers, while absolute valuation determines a company's intrinsic worth based on its estimated future cash flows and does not reference other companies or industry averages.

2. What are the benefits of relative valuation methods?

Relative valuation methods are generally easier and less time-consuming to perform compared to intrinsic valuation methods. They can be particularly useful when valuing private companies with limited financial data and provide insights into market perceptions of a company's value.

3. What are the limitations of relative valuation?

One limitation of relative valuation is that it relies on the assumption that market prices reflect the correct value or provide useful guidelines for valuing a company. Additionally, selecting the appropriate peer group for comparison is crucial, and there can be imperfections in finding truly comparable assets.