Comparing valuations with history and peers

In simple terms

A valuation ratio on its own means little. A P/E of 20 is high for some businesses and low for others. To give it meaning, analysts compare it in two ways:

• With history: where does today's multiple sit in the company's own range over the past years?
• With peers: how does it compare with similar companies today?

Both comparisons are useful, and both can mislead if the things being compared are not really alike.

Comparing with history

Calculate the company's multiple, such as P/E or EV/EBITDA, at regular points over many years, ideally a full business cycle, and note the range and the median.

Points to watch:

• Use the same definition throughout: trailing or forward, reported or recurring profit.
• Cover different conditions: a range taken only from a long boom will be too high.
• Watch for structural change: new regulation, new competitors, a major acquisition or a change in interest rates can shift the fair range permanently.

Choosing peers

A peer group is a set of companies similar enough that their valuations can be compared. Good peers:

• Sell similar products to similar customers through similar channels.
• Have similar growth prospects, returns on capital and risk.
• Are of broadly similar size, or at least you allow for size.
• Use comparable accounting and report figures you can calculate the same way.

The same industry label is not enough. A premium paint company and a basic paint company, or a private bank focused on retail customers and a public sector bank lending to large industry, may share a label but differ in almost every respect that matters for value.

Use the median of the peer group rather than the average, because one extreme value can distort an average, as the averages lesson explains.

Adjusting for differences

Even good peers differ. Before concluding that a company is cheap or expensive relative to peers, check whether the differences explain the gap.

The factors that most often justify higher multiples are faster and more durable growth, higher returns on capital, lower debt, steadier earnings and better governance. The sector valuation lesson explains why whole industries differ.

Relative value is not absolute value

If an entire sector is overvalued, a company that looks cheap relative to its peers can still be expensive. Relative comparisons tell you how a company is priced compared with others, not whether any of them are good value. The intrinsic value module covers absolute valuation, and the comparable-company valuation lesson combines the two.

Why it matters

Historical and peer comparisons are the most common way investors and analysts judge valuation. Done carefully, they quickly show whether a company's price is unusual. Done carelessly, they lead to buying deteriorating businesses because they look cheap against their past, or ignoring quality because it never looks cheap against weaker peers.

Limitations

History is useful only if the business and its environment are similar to the past. Peer groups are rarely perfect, and choosing them involves judgement that can be bent towards a desired answer. Both methods measure relative, not absolute, value.

Common mistakes

• Assuming a share will return to its average multiple.
• Choosing peers by industry label alone.
• Using averages distorted by one extreme peer.
• Ignoring differences in growth, returns and debt.
• Forgetting that a whole sector can be over- or undervalued.

Try it yourself

1. Choose a listed company and find its P/E at each year-end for the last ten years, from annual share prices and EPS.
2. Note the lowest, median and highest values, and where today's P/E sits.
3. Choose three peers and record their P/E, five-year growth, ROCE and net debt.
4. Decide whether the company looks cheap or expensive after allowing for the differences, and write down why.