In this article, two other aspects of comparable analysis will be discussed: how this relative valuation method fits into the bigger picture of comprehensive company valuation and investing strategies related to comparable analysis. Examples will focus on Singapore-listed companies to benefit domestic investors.
Comparable analysis in valuations
If the goal of valuing a company is to determine whether it is investment-worthy, there are multiple valuation methods, such as discounted cash flow (DCF) analysis, margin of safety (MOS) analysis and price-to-value growth (PTVG) analysis. However, these valuation methods generally consider only whether an investment is undervalued relative to its own fundamentals or to the market as a whole. There is little emphasis or consideration of how other similar businesses may be valued, and whether an entirely new valuation exercise is required to determine whether peers are undervalued.
Comparable analysis addresses this issue by providing investors with an overview of how a cohort of similar stocks within an industry fares financially. This can serve as a filter and prompt further research into other stocks with relatively stronger financials. Also, investors can get an overview of how similar businesses are performing within an industry or sector. From this, there may be instances where not all companies in a seemingly expensive industry are overvalued. Conversely, just because an industry such as AI is doing well overall doesn’t mean all companies within it are investment-worthy. Some companies may have underwhelming financials, while a select few stocks with extraordinary fundamentals skew the industry’s prospects.
See also: Understanding comparable analysis, Part 1
Essentially, this valuation method enables investors to look at the bigger picture without spending excessive time researching individual stocks. In other words, investors can conduct both individual- and industry-level valuations through comparable analysis.
If investors have the luxury of time, additional valuation methods, such as comparables analysis, provide a more comprehensive overview of the company under review. The caveat here, however, is that every valuation method must consistently indicate whether a company is undervalued, fairly valued, or overvalued. For example, if all three DCF, MOS and PVTG valuation methods indicate that a company is undervalued, but a comparable analysis shows that the company is overvalued. The conflicting valuations should prompt the investor to either revalue the company or attempt to understand why the valuation conclusions conflict.
If various valuation methods conflict, investors can manage this by weighting them based on the depth of the valuation. For example, if only a simple DCF is done along with a thorough comparable analysis covering multiple financial and business indicators, then a higher weightage should be assigned to the latter method. Investors should note that these methods must be quantitative and measurable for them to be objectively valued.
See also: Understanding price and value in the context of investing, Part 3
Comparable analysis is also great for identifying industry leaders and laggards based on both historical and projected financials. When an investor decides to research a stock they believe might be undervalued, they can gauge the extent to which the “best” and “worst” financials would look. For example, in a school test, this is like the lowest- and highest-scoring students for a specific subject. This allows investors to project the boundaries of how much risk a specific business would carry in a worst-case scenario of failure and the extent of the prospect for the same business if it did everything right. This also enables investors to have more justified assumptions when valuing companies, which can also be used in other valuation methods such as DCF.
Investing strategies using comparable analysis
Whether an investor chooses to use comparables analysis alone to value a company or to use an amalgamation of valuation methods that incorporate comparables analysis, their investment strategy must consider a couple of factors.
Firstly, the number of stocks. If investors choose to invest in many stocks, then comparable analysis is useful because it provides an overview of multiple stocks, enabling them to pick and choose the best within the group. This is like buying an exchange-traded fund (ETF) or investing in a mutual fund, but only buying individual stocks which investors believe are undervalued.
Aside from diversification benefits, investors would be able to manage their investment risk and goals better by performing comparable analysis. For example, in a group of 10 stocks, if the investor determines that all are undervalued, a higher allocation can be given to the stock with the highest estimated risk-adjusted return. By performing comparable analysis, this relative valuation method enables investors to quantify how much more undervalued one stock is relative to its peers. Hence, within a group of shortlisted investments, cheaper stocks with better financials should receive a larger allocation because they are more undervalued relative to others.
Next, if an investor compares a stock against its historical financials, they can allocate funds or invest in proportion to how cheaply it trades relative to its long-term averages. For example, when comparing the price-to-book (PB) ratio, stocks which trade at one standard deviation or more below the mean are considered undervalued. Similarly, stocks that currently trade at a higher dividend or distribution yield than their long-term average are attractive to dividend-focused investors.
In both examples and cases, it is very useful for investors who only monitor a handful of stocks. The strategy is to allocate more as the price-to-book ratio decreases and dividend yields increase, because they are relatively cheaper and more attractive than “normal”.
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Hence, investors who perform or prioritise comparable analysis and relative valuation methods should attempt to determine the average, median, or “normal” level for a stock, either against its historical figures or against a group of peers with similar businesses. The more a stock’s financial or quantitative figures deviate from the “normal”, the higher the allocation to this stock, assuming the deviation indicates undervaluation.
Examples
To illustrate this relative valuation method of comparable analysis, Singapore banks will be used as comparables, compared against their historical averages and regional peers, based on bank-specific ratios. The third example will be REITs and their distribution yields.
Charts 1a, 1b, and 1c show DBS, UOB, and OCBC’s current price-to-book ratios against their five-year historical averages. From these three charts, although all three banks appear to be overvalued based on historical figures, UOB is relatively the cheapest. Hence, for investors examining Singapore banks, UOB would score higher in a comparable analysis based on price multiples. Investors should not overlook that there are many other ratios that can and should be examined using historical figures.
The second example is illustrated in Table 1, where selected key bank ratios of DBS are compared against regional peers. These ratios are selected based on data availability and include net interest margin (NIM), efficiency ratio, and non-performing loans (NPL) ratio. These figures are compared against the group median, where a higher NIM is desirable, while a lower efficiency ratio and NPL indicate that the bank is relatively more attractive. Based on these figures, DBS is relatively undervalued for all 3 ratios.
Table 2 shows the dividend and distribution yields for the Singapore-listed REITs which are not suspended. The indicated yield is the estimated yield. Given Singapore’s current risk-free rate of 2.11%, almost all REIT dividend yields are relatively more attractive. Investors should, however, be wary of high dividend yields from certain REITs, as they may be either inconsistent or not paid regularly.
