Chapter 6. Relative-Value Analysis

There are two essential ways to look at the value, or worth, of an investment. The first way is determining the investment’s intrinsic value. Basically, intrinsic value is how much you think an investment is worth in isolation; it might be different than its market value. For instance, even though a bond might have a market price of $40, the net present value (NPV) of the expected cashflows, under your base case assumptions, are worth at least $50. Quantifying risks and developing the different assumptions (scenarios) and their probabilities requires a comprehensive understanding of the investment’s fundamentals and is at the core of financial analysis. Relative value, on the other hand, compares an investment’s risk-adjusted returns against other potential investments to determine if the investment is rich, cheap, or fair. In other words, all things being equal, a risky investment that is expected to return 15 percent is rich to a less risky investment that is also expected to return 15 percent. Similarly, although a bond might seem cheap because it has a market value of $40 and an intrinsic value of $50, there might be cheaper bonds with similar risk that have a market value of $40 and an intrinsic value of $60.

The key to determining relative value is isolating and quantifying the differences between investments. For instance, comparing two almost identical bonds issued by the same company with different coupons and maturity dates comes down ...

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