Relative Value
Candlefocus EditorWhen using a relative value approach, the analyst looks to compare two similar assets side-by-side and determine which gives the greatest return. These comparisons provide insight into the risk/return profile of the investments, and allow the decision maker to input assumptions and measure how things may change under different conditions. For example, they can input different interest rates and inflation levels, and get an idea of how these impacts the expected value of an asset, or measure the relative attractiveness of one market versus another.
However, a word of caution should be taken when using relative value tools, as the technique tends to lock analysts and investors into a narrow search and may lead them to the best of a group of sub-par investments. In other words, relative value may place limits on investors' creativity and focus too much attention on only a handful of investments within a very narrow field. For example, use of relative value analysis among dividend-paying stocks could cause investors to overlook high-yield stocks in other industries or asset classes altogether. While the technique can be beneficial for investors who are looking to evaluate potential investments quickly, it is important to remember that the tool comes with potential limitations.
Although relative value is often the go-to method for arriving at a final decision on what investment to pursue, it may not always be the best option. Analyzing the underlying fundamental factors of individual assets can actually provide deeper insights into a company's valuation, and identify more profitable investments. Many investors take a more comprehensive approach that employs a combination of techniques, such as fundamental research, technical analysis, and risk/return analysis, in order to make a more informed investment decision.