What it means
Absolute value asks what something is worth in itself, often by forecasting cash flows. Relative value asks a simpler question: given what similar things cost, is this one a bargain or a premium?
This is the approach most people use in daily life, such as comparing three similar laptops before buying one. In investing, the comparison usually involves a ratio.
An analyst might compare a company's price-to-earnings ratio with its sector average, or a corporate bond's yield with that of a government bond of the same maturity. Differences that cannot be explained by risk, growth or quality become candidates for a trade or a portfolio switch.
Portfolio managers use relative value to choose between options when they have to stay invested. A bond manager who must hold investment-grade debt cannot simply say that all bonds are expensive; instead, she looks for the issuer offering the most yield for the risk.
Equity analysts do the same when they pick the best-value stock within a sector. The idea also sits behind a family of hedge fund strategies that buy the cheaper asset and sell the more expensive one.
These strategies profit when the gap closes, whichever direction the whole market is heading. The trap is the phrase without a good reason.
Something may look cheap compared with peers because it deserves to be, owing to weaker growth, higher debt or a damaged reputation. Relative value tells you where to look, but you still need to understand why the gap exists.
Relative value is also a mindset for allocating a limited budget inside a company. A finance director comparing three projects, or three suppliers, is making a relative value judgement whenever she asks which one gives the most return for the money.
The same discipline of comparing like with like applies, whatever the setting.
In practice
Real-world examples.
Example
A fund manager compares two supermarket chains with similar growth and debt. One trades at 12 times earnings and the other at 16 times, so he buys the cheaper one for the portfolio. He first checks that the cheaper chain does not have an unusual risk, such as a pending lawsuit.
Example
A corporate treasurer is investing spare cash in bonds. Two issuers with the same credit rating and maturity offer yields of 4.8% and 5.1%, so she chooses the second as the better relative value. She also confirms the extra yield is not explained by weaker covenants.
Example
A real estate investor compares office buildings in two districts. Rents in one district are 20% lower per square metre, while building quality and occupancy are similar. He decides the cheaper district offers better relative value and negotiates a purchase there.
Formula
Calculation
Relative value ratio = Asset's multiple / Peer average multiple
Suppose a company trades at a price-to-earnings ratio of 15, while its sector average is 20. Relative value ratio = 15 / 20 = 0.75, so it trades at a 25% discount to peers. Its earnings per share are $4, so its share price is 15 x 4 = $60. At the sector average multiple, the price would be 20 x 4 = $80, which implies potential upside of 80 / 60 - 1 = 33.3%, provided the discount is not justified.Case study
Seen in the real world.
Silverline Asset Management is an illustrative, fictional firm that manages a $400,000,000 corporate bond portfolio. Its credit team noticed that the bonds of a regional utility paid 0.60 percentage points more than similar utilities with the same rating.
The team investigated before buying. They discovered that the utility had a planned plant closure that might create one-off costs, but its cash flows were stable and its debt was falling.
They concluded that the extra yield was higher than the risk warranted and bought $20,000,000 of the bonds. Over the next year the gap narrowed to 0.25 percentage points, and the illustrative lesson was that relative value works when you can explain, and then test, why the discount exists.
Watch out
Common mistakes.
- Assuming that anything cheaper than its peers is a bargain, when the discount may reflect real weaknesses.
- Comparing assets that are not truly similar, such as a fast-growing software firm and a slow-growing utility.
- Ignoring that the whole peer group can be overpriced, so that being cheaper than expensive peers is not the same as being cheap.
Questions
People also ask.
How is relative value different from absolute value?
Absolute value estimates worth from the asset's own cash flows, while relative value judges price by comparison with similar assets.
What measures can I use to compare?
Common choices include price-to-earnings, EV/EBITDA, dividend yield, bond yield spreads and price per square metre for property.
Does relative value work for private businesses?
Yes, advisers often use multiples from similar sales and listed peers, adjusting for size and the lack of an easily traded market.
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