Why Peer Groups are Useful for Industry and Company Analysis
We use industry analysis to better understand the big picture and a company's relative position within it. Peer groups is one comparable companies approach useful in valuation analysis (and it is also an approach broken down in the CFA Level 1 Curriculum).
As investors, industry analysis is a helpful tool because it can:
- Provide insight about the firm’s potential growth, competition, and specific risks
- Help determine the trajectory of an industry and the prospects for its overall performance
Together these two factors can help us understand a firm’s business environment and more broadly determine potential sources for return within an overall portfolio consisting of companies across many different industries.
While this type of broad comparison is very useful relying solely on industry classifications can be overly broad. If an analyst is performing a deeper dive on a company in order to determine how it stacks up within its industries it can be helpful to create something known as peer groups.
What are peer groups and why do investor's use them?
A peer group is a set of comparable companies used in valuation analysis. A peer group will generally have similar:
- Business activities
- Demand factors
- Access to capital (types and terms)
A firm can appear in more than one peer group.
How do you form a peer group?
The following are steps an analyst would use to form a peer group:
- Determine which firms are in the same industry by looking at commercial classification providers
- Examine firms’ annual reports to identify key competitors
- Examine competitors’ annual reports to see if other competitors are named or use industry trade publications to identify competitors
- Ascertain that comparable firms have similar sources of sales, earnings and product demand, and operate in similar geographies
- Adjust financial statements unrelated subsidiary data that they might include
How do you rank a company within a peer group?
In order to look at the relative valuation of companies within a peer group we generally follow a defined set of steps (note: you don’t need to memorize these steps):
- Evaluate macroeconomic factors and their relationship to industry trends
- Estimate industry variables under different scenarios
- Compare your estimates with those of other analysts, attempt to identify undervalued or overvalued sectors
- Determine the relative valuation of different industries
- Look at the volatility of industry performance
- Further segment the industry to look at different strategic groups
- Classify the industry by their life-stage
- Look at their cost-per unit cost relative to overall output (experience curve)
- Look at relevant external variables including demographics, macroeconomic conditions, government, social, and technological impacts
- Look at the competitive forces within an industry
Tying it back together: Peer Groups in Industry and Company Analysis
The process of forming peer groups is obviously tied to other forms of industry and company analysis. The CFA curriculum covers broad industry classifications, Porter's Five Forces, Industry Life Cycle Analysis, and different external influences on industry groupings. Furthermore, and perhaps very obviously, peer groups would likely be statistically correlated in terms of risk and returns.
Can you think of a time when determining relative ranking of companies would be beneficial?
Here is one example. Imagine a situation where a hedge fund is attempting to earn alpha without taking on significant market (beta) risk. One strategy to do this could be to form a long-short portfolio, where they go long a company they determine to be the best in class company in the space. To counteract this exposure they could short an equal amount of a similar company in the industry that they think will outperform. In theory the equity betas of the two companies in the same industry should be close (e.g. they are either cyclical or not cyclical). The hedge fund's profit or loss will lie in the difference in the performance of the two companies.
This type of long-short security selection strategy is discussed in more depth in Level 2 and Level 3 of the CFA, but it is interesting to start thinking about applications of the material you are learning in the curriculum.