Posts Tagged ‘gross margin’

PEER COMPARISON: UNCOVERS UNDERVALUED STOCKS

Peer comparison is one of the most efficient and effective methods of equity analysis used by analysts and individual investors. It has proved to be most widely used and accepted method that quickly shows which stocks may be overvalued, and which might make good additions to one’s portfolio. While there are other methods of determining when a stock is worth buying, such as discounted cash flow or technical analysis, peer comparison analysis remains a key tool for uncovering undervalued stocks.

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Relative Valuation: Relative valuation often considered as starting point in peer comparison analysis; it is a method of valuing a firm by comparing standardized valuation, such as price-earnings (P/E), price-to-book value (P/B), enterprise value / EBITDA (EV/EBITDA), or others that seems relevant to the investment decision metrics with those of similar companies. Let’s see how each company stacks up to the rest in the table 1.

Now the question comes: How should a company’s metrics compare to those of its peers? In other words, how fair is it for the company to carry a higher or lower valuation than the industry average and by how much?

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However, by simply using these metrics, assuming that all of the companies used for comparison should be valued equally, then naturally investors would avoid/sell PQR. But this simple analysis could be incorrect as each company should be valued differently according to its unique circumstances.

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And to measure the qualitative aspects of the companies, we use tools such as leverage and profitability metrics.

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Operating Performance, Leverage and Profitability Metrics: An investor should look at several metrics before making a decision on how a firm stacks up to its peers, including ROE, return on assets (ROA), gross margin, operating margin, profit margin, debt/equity ratio and others that may be relevant for a firm’s particular circumstances or industry. Lower ROE than its peers is a sign that the company may not turn capital into profits as efficiently as its competitors, and should be valued at a lower multiple than its peers.

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In addition, the expected growth rate of the companies in question is highly significant. Acompany with even slightly higher-than-average profit growth expectations may be valued at significantly higher multiples than its peers. Ultimately, expected profit growth is the main focus, but for young companies and industries, expected sales growth can be heavily weighted also, because these firms may be unprofitable for the foreseeable future.

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In the table above, we have seen that metrics vary considerably. A higher ROE, ROA, gross margin, operating margin and profit margin indicate better operational efficiency that have a positive effect on valuation. A higher debt/equity ratio indicates more risk due to higher leverage, and thus lower valuation. The most important metric, expected earnings growth, will generally have the greatest impact on valuation and, as we can see PQR with a much higher expected earnings growth than the industry average, is indeed valued higher than the rest by P/E, P/S and EV/EBITDA based on its current stock price (see Table 1).

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Spotting Undervalued Stocks: The next step is to use these metrics in conjunction with current valuation ratios. To do this, analyze the operational performance, leverage, profitability to determine which companies should carry a higher-than-average valuation and compare those predictions with current actual valuations. If the current valuation is lower and seems reasonable based on this analysis, then the security may present a buying opportunity. However, while some investors use quantitative econometric analysis to precisely predict how a stock should be valued based on its metrics, the vast majority view this process as more of an art than a science. So, additionally some qualitative factors must also be taken into account.

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Qualitative Factors

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Some companies have advantages or disadvantages relative to their peers based on factors not found in their financial statements. Management quality and corporate governance are some of the most widely focused qualitative factors. Corporate governance must be designed to ensure that shareholders’ rights are upheld. Every company depends on its managers for leadership and vision, both of which can affect the bottom line in the long run. The best companies will have a stable management team and enough depth of talent to weather the loss of one or two key managers without causing a major disruption to the firm’s operations or strategy.

Another very popular qualitative aspect is through Porter’s five forces analysis.

These five forces are:

•Threat of new entry

•Threat of substitution

•Bargaining power of suppliers

•Bargaining power of buyers

•Competition in the industry

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The interaction of these five forces can affect a firm’s long-term prospects for sustainable growth. If the current valuation is lower after taking various valuation metrics and qualitative factors into account, then the stock may be undervalued.

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Conclusion: Peer comparison analysis is one of the most useful tools for fundamental analysis of a stock. Since the data necessary to conduct the analysis is generally public and readily accessible on financial websites, it is easy for individual investors to employ this method of analysis for knowing undervalued scrips. Moreover, since it takes quantitative as well as qualitative aspects of company operations hand in hand, it leaves minimal room for risk and ambiguity to the investors.