A Relative Value Index (RVI) helps you compare the strength or weakness of one financial security against another and is most frequently used for stocks. RVI will only tell you something meaningful when considered in an historic context, so you must calculate RVI over a period of time as opposed to analyzing its absolute level on any given day. In addition, you should carefully consider which two stocks to compare against each other and ensure that the issuer of the two shares have some common denominator.
Relative Value Strategy
A good place to start is by selecting the two stocks you want to compare relative values for. In most instances, analysts compare shares of companies operating in the same industry, such as two airlines or two automakers. Since stocks within the same sector will be subject to similar macroeconomic dynamics, they tend to move up and down together. Relative value tells you to what extent their prices have diverged and may point to buying opportunities.
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If the price of one stock has advanced far more rapidly than another in the same sector, it may be due for a correction. If it has lagged far behind, this may be a buying opportunity. Start by selecting two shares that you think are subject to similar market forces.
Relative Value: Units of Time
Relative value calculations rely on time periods, so you will need to carefully consider and pick a time period for which to analyze relative value. While you must use multiple days, the number of days you should go back depends on multiple factors. Too few days result in insufficient data to make meaningful conclusions.
If you go back too far, however, you might have irrelevant data since one or both companies may have undergone radical changes since then, such as mergers or drastic changes in product lines. In most cases, analysts go back at least a few months, but not more than a couple of years. Consider market dynamics and data availability before settling on beginning and end dates.
Relative Value Formula
To use the relative value formula, SmartAsset indicates that one method is to divide the price of one security by that of the other and multiply the result by 100 for each day in your range. If the relative value is far lower than its historic average, the stock in the numerator is cheap by historic standards. If the figure is far above past values, the stock in the denominator is cheap compared to its past.
For example, assume that Stock A was $9 a year ago when you began tracking relative value, while Stock B was $3. The RVI was $9/$3 = 3 at the beginning. Further assume that over most of last year, the RVI hovered between 2.5 and 3.3. However, now Stock A is $14, while B is $3.40, putting RVI at $14/$3.4 = 4.12. Since the RVI is far above historic levels, Stock B (the denominator) is relatively cheap and this may be a good time to buy it.
Relative Value Considerations
Investopedia reports that sometimes focus on RVI in a way that limits their long view, which can result in money lost. As with all other metrics, RVI should never be used as the sole reason for buying or selling a financial security, as it is only one piece in a complex puzzle. Sometimes, the relative weakness of one stock is justified and may point to even further future declines in its price. This often happens when one of the companies used to calculate RVI is stealing market share from the other, resulting in dramatic price appreciation in one stock and heavy declines in the other. This kind of dynamic might be a reason to dump the losing share.