Warren Buffett is a huge proponent of value investing, which is the idea of identifying and buying undervalued/underappreciated stocks. The challenge is, how do you know if a stock is undervalued? A quick way is to compare how the stock is priced against other similar companies. The industry calls this technique the comparable company analysis.

I was first introduced to this in my valuations class back in school but found myself repeatedly using this throughout my various finance stints, be it in investment banking, private equity, deals advisory, where I began to note down the best practices used in each organization and started furiously applying this technique in my own investments. It is a fairly simple process and here’s how:  

Summary

Step 1: Identify comparable companies

Step 2: Choose an appropriate valuation multiple

Step 3: Analyse the numbers and draw preliminary insights

Step 1: Identifying Comparable Companies

Unless you are very knowledgeable about the industry, it is likely more comprehensive to filter off from a universe of companies.

Use any stock screening tool (Forbes has some suggestions here) and screen for the below.

Screening Criteria: 

1)     Public Company

We like to pick public companies because of the abundance of disclosures available, enabling us to be able to easily extract the information we need to conduct analysis.

2)     Industry Classification

3)     Business Description (Use if needed)  

Some industries might be super broad. Thus, to further narrow down your scope of comparable companies, you might choose to use business descriptions.  

4)     Geographical Locations

5)     Size (Market Capitalization or Revenue as a proxy)

Additional criteria for if you want to be more robust:

6)     Profitability(Net profit margin as proxy)  

7)     Growth Rate (Revenue growth rate as proxy)

8)     Capital Structure (Debt to Equity Ratio as proxy)

Pro-tips

Always good to perform sanity check on your list of comparable companies by searching up broker reports and seeing what other analysts are using.

Segregating the comparable companies into tiers or buckets (e.g., domestic listed, SEA listed, other APAC listed, global players) can also be helpful when performing analysis later to spot trends.

Note that these criteria are non-exhaustive, and you can play around (such as filtering for stock exchanges, etc.) depending on your specific circumstances.

Step 2: Choose an appropriate financial metric

Now that you have a list of comparable companies, the next step is to use a valuation metric as a proxy to compare the companies’ valuations.

There is a multitude of valuation metrics you could use, and each sector even has a “standard” or preferred set of metrics. You need to evaluate which multiple is most appropriate for your specific industry/circumstances.

You can also be creative by making up your own multiple depending on the industry. For example, Enterprise Value / Gross Merchandise Value for e-commerce platforms and Enterprise Value /Reserves for oil and gas.

Optional Step: Adjust multiples if needed

Adjustments may be necessary to ensure that a like-for-like comparison is used.

1. Make sure the same period is being compared. FY2021 figures for 2 different companies might be referring to different time periods if their financial year-end is different. Adjust the figures by playing around with quarterly/semi-annual reported figures.

For example, company X’s financial year end could be 31-Dec. FY2021 income statement would thus be referring to its performance from 1-Jan-21 to 31-Dec-21. If you want to obtain performance figures from 30-Sep-20 to 30-Sep-21 because company Y’s financial year end is30-Sep-21, you can deduct Q42021 from FY2021 figures and thereafter add back Q42020 figures.

2. Removing “one-offs” or non-recurring items which may skew the valuation. Examples include the following: 

• Grant income or relief from covid-19
• Restructuring charges
• Large gains and losses on the sale of businesses/assets
• Impairment of fixed and intangible assets
• Large one-time charges

3. Adjusting for the right number of shares. Check the notes to the financial statements to ensure that you are using the right number of shares to derive your valuation multiples.

• Companies may have >1 class of shares. Make sure all of them are accounted for
• Company may have conducted a stock split, share buyback or issued more shares. Make sure you use the latest data you can obtain
• Consider share options to obtain diluted share outstanding. Assume all in the money options are converted and use the treasury method to calculate dilution (Link) 

However, note that this step is immensely time-consuming. After all, you’ll need to scrub through the income statements and notes of 6-7 companies and calendarize their financial statements by adding/subtracting figures from quarterly and semi-annual earnings reports. You are more likely to be doing this in an investment bank when you’re being paid thousands for financial advice and thus, your numbers are expected to be as precise as possible. For retail investors like us, such efforts might not reap significant returns since the changes in the end output are unlikely to be material.

Step 3: Analyse the numbers and Draw Preliminary Insights

Companies with a higher valuation multiple are more expensive than companies with a lower valuation multiple. Hence, you will want to focus your efforts on companies with lower valuation multiples.

Optional Step: Visualizing the Output

You will probably end up with a table like the one below if you are doing this in excel. You can also choose to plot it on a bar chart for better visualization.  

Limitations of this method

Each company is unique in its ways and thus, identifying a pool of truly comparable companies is the most challenging and arguably not possible.

Furthermore, the output you obtain will also only be an indication of how the market perceives the value of the companies and not a reflection of the intrinsic value of the company. Ultimately, value should never be approached with just 1 method, but from several perspectives. Here, we focused on the relative capacity of the company to generate value compared to comparable companies (market approach). To be comprehensive, we need also measure value through the intrinsic capacity to generate cash-flows(income approach) and the cost to replace current assembled assets that generate cash flows (cost approach).

What’s next?

Researching stocks is extremely time-consuming and thus, this method can serve as a quick way to identify likely undervalued stocks for you to be more targeted in your research. You should never make your decision to purchase the stock by only looking at comparable companies analysis. You will still need to develop well-researched investment theses.

I will be writing more about research best practices and other valuation methodologies in future articles. Stay tuned!