1. Parameters and grouping
In this relative valuation method, an investment must be more attractive or undervalued relative to other companies being examined. Hence, it is important to determine the group of companies or peers against which a specific stock should be examined.
A simple and common way to do this is to group companies by sector or industry. The more detailed the grouping, the better, as businesses are likely to be similar, making comparisons more meaningful. For example, under Singapore Exchange’s sector classification, there are 100 companies classified in the real estate sector. This grouping is too broad, as real estate developers, REITs, real estate service companies and many others are all grouped under the same sector.
If, for example, REITs are chosen, then it may be sufficient to perform a comparable analysis. Investors may also further curate this list by REIT type, including industrial, commercial and office. However, investors should be wary of not over-curating or over-filtering the group of comparable stocks. If there is only one other stock in a group of comparables, then the comparison might be skewed because the “average” is only based on one other stock.
See also: Understanding price and value in the context of investing, Part 3
To resolve this issue, investors should attempt to have at least five stocks in the group of comparables. Businesses that are unlike the examined company should not be added to the group to meet the minimum of five stocks. Instead, investors can broaden their geographic screen to include similar REITs on other stock exchanges. For example, if there are only two Singapore-listed retail REITs, investors can add other retail REITs from developed Asian countries or even from developed economies globally.
2. Other comparisons
If a stock cannot be grouped with similar peers, it can be compared against itself. For example, a company’s financials can be compared against its historical figures, as this is a relative comparison. Again, the goal is to determine whether a company is relatively more attractive than it was in the past or relative to a peer group average.
See also: Investing what-ifs: Conducting a scenario analysis
3. What to compare?
Comparable analysis is versatile because almost everything in a company’s financials can be compared with its curated peer group.
One of the main comparisons investors should make within the peer group is to compare price multiples. This includes ratios such as price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-earnings before interest, taxes, depreciation and amortisation (EV/Ebitda). Companies which have below-average price multiples are undervalued, while those with above-average multiples are overvalued. For example, Singapore Telecommunications (Singtel)’s current P/E ratio of 13 times is lower than the curated peer group average of 22.4 times, implying it is relatively cheaper, undervalued, and more attractive than peers.
Next, investors can compare profitability ratios. Examples of key profitability ratios are the return on assets (ROA) and return on equity (ROE). Also, ratios which compare a company’s margins should be conducted. Margins are an important comparison within a peer group, as they indicate which companies have stronger moats or competitive advantages relative to peers. Higher-than-average ROA, ROE and margins such as gross, operating, and net margins are desirable, as they indicate relatively more attractive companies within a curated peer group.
Another key comparison is a company’s financial safety. These can be deduced from a company’s balance sheet and financial safety ratios. For a company’s liquidity, the cash ratio, quick ratio and current ratio can be compared within the curated peer group. For a company’s solvency, the net debt-to-equity ratio and the interest coverage ratio (ICR) can be compared. For default and bankruptcy, the Altman Z-score can be used within the curated peer group.
It is important to note that the absolute figures or values of these ratios also matter when assessing financial safety. For example, if a credit rating of a company under Moody’s is Ba1 or lower, then it is junk, although Ba1 is a “safer” junk than a company with a rating of Ca. Within a curated peer group, only companies with an investment-grade rating should be considered; companies with a junk rating should automatically be deemed overvalued, risky, expensive and unsafe. For liquidity ratios, a current ratio of 1 or higher is generally considered safe. In contrast, for solvency ratios, any company with net debt-to-equity below 100% and an interest coverage ratio (ICR) above 2 times is considered adequate. Any Altman Z-score below 1.8 should indicate that a company is high-risk.
Aside from financial safety, a company’s sentiment can also be compared, as it may influence a stock’s short-term price movements. Specifically, the analyst estimates and calls on a stock, along with their projected financials. Singtel, for example, has very good sentiment over the next 12 months, with 16 “buy” calls, one “hold” call and no “sell” calls, and an average target price implying over 20% upside from its current trading price. Within the curated peer group, investors can pick and choose stocks with better sentiment. Still, they must be wary that this sentiment is usually short-term and may change significantly based on news and results affecting the stock.
For more stories about where money flows, click here for Capital Section
This list is non-exhaustive and can be tweaked based on an investor’s preference for what they consider important when valuing a company.
4. Special comparisons
For certain industries or types of investors, special comparisons can and should be made. These comparisons are usually company- or industry-specific and usually include business metrics.
One example is comparing banks such as DBS Group Holdings, Oversea-Chinese Banking Corp and United Overseas Bank. Instead of using traditional financial ratios, investors can compare bank-specific ratios to determine which banks are most undervalued. These ratios include, but are not limited to, net interest margin (NIM), efficiency ratio, and provision for credit losses (PCL).
Another industry which can be compared outside the usual quantitative ratios is REITs. Some financials and ratios that can be compared within a curated REIT peer group include price-to-funds-from-operations (P/FFO), net operating income (NOI), debt service coverage ratio (DSCR) and capitalisation rate (cap rate).
5. Historical and projected comparisons
In addition to historical and current financials, investors can use projected financials to compare and identify relatively cheaper stocks. For example, forward price multiples such as forward P/E, forward P/B and forward EV/Ebitda can be used within the curated peer group.
For historical figures, if the company is being compared against itself, then the mean and standard deviation can be utilised. Say an investor is comparing P/B ratios: if the current or forward P/B is one standard deviation below the mean, it is undervalued. However, if the P/B is more than two standard deviations above the mean, then it is strongly overvalued.
6. Real-life example
Table 1 compares dividend yields for companies in the Straits Times Index (STI). Given that the average dividend yield for companies in the STI is 4.7%, any company which has a dividend yield above this figure is relatively undervalued. Also, relative to the risk-free rate of 2.0%, almost every company that pays dividends exceeds this figure, so even on an absolute basis, most companies in the STI are undervalued for dividend-focused investors.
Conclusion
Investors can use comparable analysis to identify companies that are quantitatively undervalued based on financial ratios or figures they prioritise individually. To reiterate, within a group, cheaper stocks with better financials should be bought because they are more undervalued relative to others. The next part of this series will look at examples and investing strategies for the different types of investors in depth and how comparable analysis fits into the bigger picture of comprehensively valuing a company.
