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Understanding Absolute Rating Systems
As the legendary investor Peter Lynch once said," Know what you own, and know why you own it.". This statement can be applied to the relative rating system - it's not just about the company itself but how it stacks up against its competition.
In an absolute rating system, a stock is evaluated based on its intrinsic value, irrespective of the broader market or industry peers. Analysts usually estimate this intrinsic value using valuation methods such as the Discounted Cash Flow (DCF) analysis or Price/Earnings (P/E) ratios.
For instance, if an analyst believes a stock is undervalued compared to its intrinsic value, they might rate it as a 'Buy.' Conversely, if they think the stock is overvalued, they may rate it as a 'Sell.' This rating is, therefore, 'absolute' because it is based purely on the analyst's assessment of the stock's value and potential returns.
As Benjamin Graham, the father of value investing, famously said," Price is what you pay, and value is what you get.". This quote encapsulates the philosophy behind absolute ratings - focusing on the inherent value of a stock rather than its price relative to other stocks.
Deciphering Relative Rating Systems
In contrast, a relative rating system evaluates a stock compared to other stocks in the market or within the same sector. Rather than focusing solely on intrinsic value, analysts look at a company's performance and prospects relative to its peers.
For instance, if a technology stock is expected to outperform other stocks in the tech sector, an analyst might rate it as 'Outperform' or 'Overweight.' If it's expected to perform on par with the sector, it might be rated as 'Neutral,' if it's expected to lag behind its peers, it might receive an 'Underperform' or 'Underweight' rating.
As the legendary investor Peter Lynch once said," Know what you own, and know why you own it.". This statement can be applied to the relative rating system - it's not just about the company itself but how it stacks up against its competition.
Absolute vs. Relative - Which One to Use?
Both absolute and relative rating systems have their strengths and weaknesses. Absolute ratings focus on intrinsic value and can help identify undervalued or overvalued stocks regardless of market trends. However, they can sometimes miss the bigger picture of a company is performance relative to its peers or the broader market.
On the other hand, relative ratings consider the competitive landscape, which can be crucial in sectors where competition directly impacts a company's performance. However, a stock may be rated favorably on a relative basis while still being overvalued on an absolute basis.
The best approach may depend on your investing style and philosophy. Some investors may prefer the focus on intrinsic value that absolute ratings provide, while others might appreciate the market context provided by relative ratings.
Conclusion
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TheInvestmentAnalyst.com is a global investment education and training business founded by Geoff Robinson, formerly a 10x Number 1 ranked analyst, and UBS Managing Director. Our InsightOne App is designed for individuals to develop real-life investment analysis skills through AI-powered coaching, market simulation and interactive data tools. Our In-Person Training delivers expert-led programmes for universities, corporate teams and financial institutions worldwide.
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