Peer Group for Equity Valuation

A company’s industry classification is useful as a starting point for identifying a company’s peer group. While some comparable companies are likely to exist within the same industry group, others will likely require significant adjustments before comparison or compete in an entirely different market. To construct a preliminary list of peer companies, it is useful to review the subject company’s annual report, the annual reports of competitors, and industry trade publications to identify comparable companies.

An analyst must verify that a significant portion of a peer’s revenue and operating profit are derived from similar business activity as the primary business of the subject company. Furthermore, the analyst should examine if the potential peer company faces a demand environment similar to that of the subject company. There may be limited value in comparing companies in two different stages of the business cycle. If the potential peer company has a finance subsidiary, the analyst may need to make adjustments to reduce the impact of the finance subsidiary within the relevant financial information.

Question

Which of the following is least likely to be useful when attempting to identify a peer group for a subject company?

1. Screening for companies with similar financial ratios.
2. Looking through the subject company’s annual reports.
3. Analyzing other firms within the subject company’s industry group.

Solution

The correct answer is A.

While peer companies may have similar financial ratios, using a financial ratio screen is a poor way to first identify a company’s peer group. There may be similar competitors facing the same demand environment that are far different in terms of efficiency, profitability, leverage, etc.

B and C are incorrect. The subject company’s annual report will likely contain direct mentions of competitors and there are likely to be a number of relevant peers within the subject company’s industry.