Relative Value

Relative value is the value of an asset or commodity that makes it attractive to investors. It is assessed by comparing it to another asset or, to a particular instrument, the appeal of one maturity over another, as measured by risk, liquidity, and return.

It is used to make investment decisions. Investors will examine competing companies' financial statements before choosing an investment. In light of this, they will decide whether to proceed with the project. Investors may examine the company's footnotes and economic data in order to contrast it with other businesses of comparable size.

Relative value is the value derived from an asset determined by valuation in relation to other similar assets. It differs from absolute value and is used to compare and make investment choices. Investors interested in purchasing stocks or assets, such as companies, will start by comparing similar companies or assets. For example, a tech company's share performance will be compared to that of another tech company. This is because similar companies tend to have comparable economic dynamics and often move in correlation with one another. As a result, each stock price typically represents how the market value compares to one another.

For the same, investors may consider market capitalization, profit, sales figures, price-to-earnings (P/E) ratio, enterprise value (EV), earnings before interest, taxes, depreciation, and amortization (EBITDA) figures, among other things. Relative value trading can reveal price divergence and emphasize potential buying opportunities. If the price of an asset has dropped from the standard price point or a previous high, it could be an indication to buy. On the contrary, if the asset's price has soared quickly from one level to another, it may indicate an upcoming market correction.

An asset's R-value to another can be helpful in identifying potential opportunities with less well-known investments. Therefore, using relative values can aid in identifying relative market strengths and weaknesses. This technique is beneficial for investors looking at commodity prices because it enables them to spot relative strengths or weaknesses between two commodities that other methods may not otherwise detect. Additionally, the relative value strategy is only reliable when applied over prolonged periods (such as years or months); these values are subject to change over brief periods and, hence, might only sometimes give traders the most significant data for day-to-day trading.

Let us look at some examples to understand the concept better:

Example #1

Let's take the example of two companies, A and B. Company A has been traded at an average price-to-earnings multiple ("P/E") of 25x. For the same year, its competitor, Company B, traded at a P/E ratio of 20x. These historical prices indicate a PE ratio of 1.25x between Company A and Company B, indicating that over the last five years, Company B's PE ratio has been 1.25x greater than Company A's. Suppose the PE spread between companies A and B increased from 1.25 to a higher number among other factors, the investor may find company B overpriced compared to company A. hence, to tackle the situation, they may decide to company A and short shares of B in expectations of the spread retracting to the historical ranges.

Example #2

Let us consider an extended version of the previous example. Suppose Dan, an investor, wants to invest in a company, and he is considering companies A and B and another new company, C. All of these companies are tech companies that started around the same time. All three have a good market presence. However, company A has the highest market capitalization and net income but the second-best price-to-earnings ratio. Company B has the second highest market capitalization and net income but the lowest price-to-earnings ratio (PE ratio). Company C has the lowest market capitalization and net income but the highest price-to-earnings ratio. After looking into it, Dan understands that A is overvalued compared to B and undervalued compared to the PR ratio of C. He could choose by going by the highest market capitalization and choosing A, as they are considered safe and often have a long history in business, or he could choose C for having a better PE ratio.

Example #3

An article published on November 8, 2023, talks about how the hedge fund sector gains due to the macro and relative value of asset classes.

In October, macro strategies led hedge fund gains amidst heightened volatility due to geopolitical and interest rate risks. The HFRI Macro (Asset Weighted) Index rose +0.7%, increasing its YTD return to +2.6%. Macro sub-strategy performance was notable, particularly in discretionary and active trading strategies. Fixed income-based, interest rate-sensitive strategies also saw gains, with the HFRI 500 Relative Value Index adding +0.2%, driven by volatility and sovereign bond exposures.

The key differences between the three concepts are as follows: