Unveil Undervalued Stocks: The Peer Comparison Method

Finding undervalued stocks is part of optimizing an investment portfolio and improving long-term results. One widely used and effective way to uncover these opportunities is peer comparison, a method that professional analysts and individual investors use to evaluate companies against similar firms in the same industry. A closer look at how peer comparison works, and how it compares against other valuation approaches like discounted cash flow (DCF) and technical analysis, can sharpen decision-making and strengthen overall investment strategies.

Understanding Relative Valuation in Peer Comparison

Relative valuation is a method of valuing a firm by comparing standardized valuation metrics with those of similar companies, and it is generally the starting point in peer comparison analysis. It is really quite simple: First, choose relevant ratios, such as price-to-earnings (P/E), price-to-sales (P/S), enterprise value / EBITDA (EV/EBITDA), or others that you deem relevant to the investment decision, then find these ratios for each company in the peer group and see how each company stacks up to the rest.

The peer group is often made up of other firms in the same industry, but peers can also be chosen based on other circumstances of the firm, such as the life-cycle stage. Figure 1, below, shows relative valuations within the quick-service restaurant industry.

Most valuation metrics can be calculated easily, so the question becomes: How should a company's metrics relate to those of its peers? In other words, does the company deserve to carry a higher or lower valuation than the industry average, and by how much should it deviate?

Among the companies listed in Figure 1, we see that one company, Chipotle Mexican Grill, is valued at significantly higher multiples than the rest of the group by all three measures of valuation. Were we to simply use these metrics and assume that all of the companies used for comparison should be valued equally, then we would naturally want to sell Chipotle (or at least avoid buying it). But this simple analysis could be incorrect because we must assume that each company should be valued differently according to its unique circumstances.

We use the group to find average valuations, but the next step is to determine how each company should be valued relative to the rest. To do this, we use tools such as leverage and profitability metrics to measure the qualitative aspects of the companies in question.

Analyzing Leverage and Profitability Metrics

When employing peer comparison analysis, leverage and profitability metrics alone will not point directly to the fair value of a firm, but they can give an investor an idea of how a firm should be valued relative to its peers.

If you know that Company X has a return on equity (ROE) of 10%, but the rest of its close competitors carry an ROE of 15%, it is a sign that Company X may not turn capital into profits as efficiently as its competitors, and should be valued at a lower multiple than its peers.

Of course, an investor should look at several metrics before making a decision on how a firm stacks up to its peers, including ROE, return on assets (ROA), gross margin, operating margin, profit margin, debt/equity ratio, and others that may be relevant for a firm's particular circumstances or industry.

In addition, the expected growth rates of the companies in question are highly significant. A company with even slightly higher-than-average profit growth expectations may be valued at significantly higher multiples than its peers. Ultimately, expected profit growth is the main focus, but for young companies and industries, expected sales growth can be heavily weighted also, because these firms may be unprofitable for the foreseeable future.

In Figure 2, we see that metrics for quick-service restaurants vary considerably. A higher ROE, ROA, gross margin, operating margin and profit margin indicate better efficiency and/or operating conditions, which will have a positive effect on valuation. A higher debt/equity ratio indicates more risk due to higher leverage, and thus lower valuation.

The most important metric, expected earnings growth, will generally have the greatest impact on valuation and, as we can see, Chipotle, with a much higher expected earnings growth than the industry average, is indeed valued higher than the rest by P/E, P/S, and EV/EBITDA based on its current stock price (see Figure 1). Expected earnings growth is the only metric in the above table that cannot be calculated from the companies' financial statements.

In Figure 2, this earnings growth figure is taken from consensus analyst estimates. Although it is possible for individual investors to model earnings growth themselves, great care should be taken to keep estimates reasonable because this variable can affect valuation significantly.

Identifying Undervalued Stocks Through Peer Analysis

The next step is to use these metrics in conjunction with current valuation ratios to spot undervalued stocks. To do this, analyze the leverage, profitability, and other relevant metrics to try to determine which companies should carry a higher-than-average valuation, then compare those predictions with current actual valuations. If the current valuation is lower than seems reasonable based on this analysis, then the security may present a buying opportunity.

However, this is rarely as easy as it may seem. While some investors use quantitative econometric analysis to try to precisely predict how a stock should be valued based on its metrics, the vast majority view this process as more of an art than a science. Additionally, qualitative factors must also be taken into account.

Evaluating Qualitative Factors in Stock Analysis

Some companies have advantages or disadvantages relative to their peers based on factors not found in their financial statements. Management quality is one of the most widely studied qualitative factors because every company depends on its managers for leadership and vision, both of which can affect the bottom line in the long run.

The best companies will have a stable management team and enough depth of talent to weather the loss of one or two key managers without causing a major disruption to the firm's operations or strategy. Some factors focus on minimizing risks faced by investors; for example, corporate governance measures are designed to ensure that shareholders' rights are upheld.

Another very popular way to look at qualitative aspects is through Porter's five forces analysis. These five forces are:

1. Threat of new entry
2. Threat of substitution
3. Bargaining power of suppliers
4. Bargaining power of buyers
5. Competitive landscape within the firm's industry.

The interaction of these five forces can affect a firm's long-term prospects for continued success.

Like leverage and profitability metrics, qualitative factors should be analyzed to determine whether a company is in a better or worse position than its peers, and thus should be valued at a higher or lower multiple. If the current valuation is lower than seems reasonable after taking all of these metrics and qualitative factors into account, then the stock may be undervalued.

Peer Comparison vs. Discounted Cash Flow: A Comparative Analysis

While we will not discuss discounted cash flow (DCF) analysis in depth here, there is one key difference between peer comparison and DCF valuation methods that should be noted. Peer comparison analysis assumes that the peer group is, on average, fairly valued. If this does not hold true, the entire industry may rise or fall and take every stock with it.

In 2000, an investor using peer comparison to analyze the internet industry might have found a stock with potential to outperform its peers, but the flaw in this logic would have been that its entire peer group was overvalued and fell dramatically over the next couple of years. Any security that was selected at the time as the most attractive would probably still fall because the industry was revalued at a lower overall valuation.

Discounted cash flow, if accurately implemented, is not subject to this problem. Because DCF does not depend on how a firm is valued relative to others, this method can, theoretically, value a firm without regard to the value of its peers, or even the overall market. Both methods, however, do involve a great deal of judgment and discretion, and must be conducted with care in order to achieve valid results.

The Bottom Line

Peer comparison analysis is one of the most useful tools for an equity analyst or individual investor. Because the data necessary to conduct the analysis is generally public and readily accessible on financial websites, it is easy for anybody to begin employing this method of analysis.