Relative valuation refers to the process by which investors judge companies compared to other companies within the same industry. By using statistical information like financial ratios, investors can determine whether certain companies within an industry are valued by the market at a level different than their actual worth. In addition, relative valuation can be done by comparing a company's ratios with its ratios from past years. This valuation method may be flawed if there are other factors affecting the market price of a company that are not reflected by the ratios.
Investors are constantly looking for ways to properly judge the value of companies on the stock market in an attempt to pick worthy stocks. One way to achieve this is to study financial ratios, which compare two aspects of a company's operations by dividing one statistic into the other to produce the ratio. These ratios can be used to measure a company's efficiency, its profitability, and many other things, and they are at the heart of relative valuation.
The concept behind relative valuation is that these ratios mean very little without some sort of context to measure them. For example, knowing that a company has a particular price to earnings ratio, which compares a company's market price to its earnings statistics, is worthless information all by itself. Taking that earnings ratio and comparing it to other companies within the same industry can indicate whether the company is being properly judged by the market. In a best-case scenario, an investor might be able to use this type of valuation to find stock bargains.
Another way that relative valuation may be achieved is by comparing a company's current ratios with its past performance. This can help to shed light on the progress that a company is making. It can also help investors see if the company is trending one way or another. For example, a company may have ratios that place it at the bottom half of its industry, but if those numbers have steadily improved from past years, the company may actually be ready to move into the upper echelon of the industry.
It is important to note that relative valuation is best practiced in conjunction with a more subjective analysis of the company in question. A company may indeed be underrated by the market, or there could be mitigating factors that are limiting its potential, like poor leadership or a bad business plan. Simple valuation comparisons would not show such shortcomings, so investors should be ready to combine statistical evidence with thorough study of a company's intangible qualities.