When choosing an investment, there are many ways to evaluate assets. Some investors use relative value, which compares potential investments. It includes measures such as liquidity, risk, and return. But how can investors use it? Is it the only choice when filling out your portfolio?
What is Relative Value?
Relative value determines an asset’s value when accounting for the value of similar assets. Relative value is not to be confused with an asset’s absolute value. That only considers the actual asset’s value and doesn’t compare it to other assets. Often, investors use the price-to-earnings ratio of a stock to determine its relative value.
Before investors make an investment decision, they will compare financial statements from competing companies. As a result, they will decide whether they want to move forward with the endeavor. Investors may also review the company’s footnotes and economic data to compare it to similar companies.
How to Calculate Relative Value
First, identify similar assets or companies. In most cases, you’ll want to compare shares of companies in the same industry such as two technology companies or two airline companies. Because similar companies have comparable macroeconomic dynamics, they tend to move in correlation to one another. This means they move up and down at the same time. Investors will want to look at market capitalization, sales figures, and revenues of each company. Each stock price will denote how the market value of each compares to one another.
Relative values can identify price divergence which may highlight buying opportunities. If the price of one asset has advanced more rapidly than the next, this might be a sign that a market correction is necessary. Conversely, if the asset has fallen behind, this could be a sign of a potential buying opportunity.
Next, determine a period during which you want to analyze the relative value. Generally, you will want to select a timeframe of no less than a few months and no more than a few years. If you don’t go back far enough, data could be inconclusive and if you go back too far, both companies may have undergone series changes such as a merger.
Then, divide the price of one share by the other and multiply by 100. Do this for each day in your range. If the relative value of the stock is significantly lower than its historic average, the stock in the numerator is cheap by historical standards. If the relative value is significantly greater than the historic averages, the stock in the denominator is cheap compared to its historic figures. By assessing these historic prices, you can determine if a stock is undervalued or overvalued.
Relative valuation is popular due to some of the advantages it offers. For starters, it’s less time- and resource-intensive than a valuation such as discounted cash flow. This is due to the substantial amount of data that the calculation requires. If an investor lacks time and access to information, they might consider relative valuation as an alternative.
Another advantage is that relative valuation is much more likely to represent the current state of the market.It measures relative values instead of intrinsic values. Therefore, in a market where all stock prices are up, the relative valuation is likely to yield higher values for these stocks in comparison to cash flow valuations.
While relative valuation might be easier to put together, sometimes gathering a group of comparable companies can yield inconsistent estimates. By using the relative valuation, investors might ignore key variables such as growth or cash flow potentials.
However, the biggest disadvantage of this calculation is companies may not always trade compatibly with other companies in their industry. They can trade on multiples lower than their peers for a variety of reasons. Sometimes it’s because the market hasn’t identified a company’s true value, which may seem like a buying opportunity. Other times, investors should completely stay clear of a company. While it may seem like the company is selling for cheap, it could be because the company is on the verge of failure.
The Bottom Line
There are a lot of different ways to identify good investment decisions. If you choose to use this strategy to evaluate investments, it’s important to do your homework. The objective is to identify the difference between companies and determine which deserve high valuations. Instead of just selecting companies within the same industry, it’s wise to find companies with similar underlying fundamentals.
However, to make the best investment decision possible, investors need all of the tools and resources they can access. Relative value has its drawbacks and traps. Consider using it alongside other valuations such as discounted cash flow to understand the true value of a company.
- A financial advisor helps you put together an investing plan that will utilize several the above types of investments. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your stocks with our capital gains tax calculator.
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