Stocks traders focus on many matrices to determine the relative value of a stock. Financial results, multiple expansion, and macro events are some of the techniques used by analysts to determine the value of a stock price.Another technique that you can use to determine if the price of a stock is rich or cheap is to measure the price relative to another company in the same business, or relative to the entire sector or even a major index. This relative value analysis will help you evaluate whether the price is undervalued over overvalued, and can even help you develop a trading strategy.
Looking at the Ratio
One of the best ways to look at the relative value of a specific stock is to evaluate the stock relative to one of its peers. For example, you can find shares of stocks through iFOREX share trading that are in similar businesses such as Google and Facebook or BMW and Honda, or even Coke and McDonalds. You would then evaluate the ratio of one stock relative to another to determine if the price of the stock is rich or cheap on a relative value basis.
For example, if you look at a chart of the ratio of FB relative to GOOGL, you can see the historical path of the ratio. The ration is moved higher throughout 2017, moving up to levels that are at all-time highs. Facebook would now be considered priced relatively expensive when compared to GOOGL.
You can use several technical analysis techniques when you are evaluating the ratio, to determine if it is rich or cheap. The chart shows its historical range. The Bollinger band analysis that shows a 2-standard deviation range of a 100-day moving average. The spread moved above this level and is hovering near it, which is elevated relative to the historical past 100-days. Some investors use this technique to generate buy and sell signals on stock or on pairs of stock. For example, if the spread moved above the Bollinger band high, a sell signal is generated. If the spread of the pair moves below the Bollinger band low a buy signal is generated on the spread.
Evaluating an Sector or Index
An alternative to looking at two stocks, if to look at a stock price versus a sector or even an index. For example, you could look at the ratio of Facebook relative to the Nasdaq 100. Here you would divide FB by the Nasdaq 100 and analyze the spread. If you have access to specific sector ETFs you could look at FB versus a technology or social media ETF and determine if it is rich or cheap.
It’s important when you are doing this type of analysis to monitor the ratio as opposed to looking at one price minus the other price. This will allow you to consider a scenario where both prices move higher rapidly, but one stock is at a much higher level than another. For example, GOOGL is 925, and a 10% increase would be $92.5. FB is at 167, and a 10% increase is $16.7. If you look at the spread, the ratio would be unchanged where if you subtracted FB from GOOGL, the change would be $75.8.
If you are looking to find a way to analyze stocks, you can add spread analysis to your arsenal, which allows you to determine if the price is rich or cheap relative to its competitors, a sector or a broader equity index.