If we could know the value of an asset in and of itself, we’d be able to derive its absolute value — which I likened in a previous article to a God’s eye view or a view from nowhere.

Perhaps an easier task is comparing an asset’s value relative to its past performance or even another similar asset?

This is called relative valuation, and it’s not as straightforward as it might seem. Once we get to grips with relative value for traditional assets, I'll follow up with a second part on whether relative valuation works for cryptocurrencies.

P/E Ratio as the Basis of Relative Value

While there are several ways to obtain the relative value of a stock, the most common method is to look at the price-to-earnings ratio (P/E ratio). The simple formula:

• divide the stock price per share by the earnings per share.

To make this metric a relative valuation, the P/E ratio can be compared to the past performance of the same stock or to the P/E ratio of other stocks.

As an example, let’s look at a cannabis stock.

At the time of writing, Tilray Brands, Inc. (TLRY) has a P/E ratio of 7.20. (This means that if you bought 1 share of stock, it would take just over 7 years to start earning.)

To derive that metric, we can either look it up on Yahoo! Finance or calculate it ourselves by dividing 2.95 by 0.4100.

TLRY’s P/E ration is 7.20 (remember this number as we’ll come back to it below).

Now we’re in a position to find relative value.

How To Find Relative Value?

I’m going to breakdown relative value into two forms.

• intra-relative
• inter-relative

Intra-relative P/E

By “intra-relative”, I mean comparing P/E within (intra) a company’s history.

One form of relative valuation is to compare the current P/E ratio to past performance. Let’s say that we want to determine how TLRY has done compared to the previous year. Unless you have this information to hand, you’ll have to look up historical data for stocks. While you cannot get precise to-the-minute information, you can basically get enough of a snapshot on websites like Microtrend.

For the sake of simplicity, let’s say we have last year’s P/E ratio recorded as 8.90.

To derive a comparison, use the following formula:

• Current P/E ratio divided by past P/E ratio

For our example, we’ll use the P/E ratio from TLRY we denoted in the previous section. So:

• 7.20 / 8.90 = 0.8989

This calculation is often referred to as the relative P/E. Here’s how to understand this calculation:

• Any comparative factor equal to 1 means that the earnings cost is the same between the asset’s compared (or in this case, the time slice of the respective asset in question).
• Any comparative factor greater than 1 means that the earnings of the asset at present are more expensive.
• Any comparative factor less than 1 means that the earnings of the asset at present are less expensive.

What does this mean? A higher relative P/E means that a company’s stock may be overvalued. It can also mean that the company is in a growth phase and spending more to make more. Conversely, a lower relative P/E means a company’s stock may be undervalued; or that it may be spending less.

In turn, each of these hypotheses lead to other questions — why might a company be spending less? Is it expecting some macroeconomic event, or is it restructuring in the near future?

In sum, the general indicators in a relative valuation should always be informed and supplemented by further research into the stock.

Inter-comparative P/E

By “inter-relative”, I mean comparing P/E between (inter) companies.

Let’s look at two pharmaceutical stocks in Johnson & Johnson and Pfizer. At the time of writing, here are the respective charts:

We can simply compare the P/E ratios between the two companies.

• JNJ = 24.62
• PFE = 9.75

Take from it what one may.

A difference of 14.87 is nothing at which to balk. All things being equal between the two companies, one could surmise that JNJ is overvalued in comparison to PFE. But for this conclusion to be reasonable, it would depend on assessing a lot of other factors, such as company history, projects, etc. Maybe JNJ suffered from a recall of one of its products that in the long-term wouldn’t have too much effect?

In other words, the “all things being equal” clause (or ceteris paribus) really doesn’t hold much water. So more research is usually required.

But just to ram home the point, here’s a great example from Sebastian Purcell when asking whether Apple or Tesla is a better tech investment (at the time of his article in Oct 2021).

• Apple had a P/E ratio of 27.93
• Tesla had one of 408.66

“So, Apple is a better value than Tesla, right?

Probably, but it’s not that simple. Tesla is also growing a lot faster than Apple and it’s the leader in a completely new industry. Tesla not only does electric vehicles, but is changing the model of making cars.

A Tesla has a 1,000,000 mile warranty. Most cars have about 100,000 miles warranty. A Tesla is designed to last a person 30 years, while most cars have a “primary” life of about 10 years. Conventional cars are designed to be aesthetically obsolete in 5 years, because car companies make money selling cars. Tesla is looking at 30 year replacements.

How will Tesla make money?

The answer is that they’ll sell you a subscription to their autopilot (and other software upgrades). In short, they’re moving to the Netflix model of revenue. That AI will also be sold and deployed in other areas, again with subscription services.”

A lot of factors to weigh, not to mention how legislation might affect government funding for green energy type corporations.

How This Can Be Applied

Finding relative value is straightforward in the sense of a calculation, but trying to find the various factors accounting for differences in value is not so easy.

At the very least, relative valuation provides a decent frame of reference from which you can begin your deeper dives into the history and future performance of an asset.

After all, from one philosophical perspective, relations are relative . . . “all the way down”.

Stayed tuned for a follow up on relative valuation and cryptos. Does it work?

This article was originally published on Medium and is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.

Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.

If you found this helpful, Subscribe to The Art of the Bubble’s free newsletter.

Join us on Discord for live chat and daily updates.