D: Explain the relation of “peer group” as used in equity valuation, to a company’s industry classification

Question 1

A peer group should consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital. To form a peer group, the analyst will often start by identifying companies in the same industry, but the analyst should use other information to verify that the firms in an industry are comparable.

Answer 1

A peer group is a group of companies engage in similar business
activities whose economics and valuation are influenced by closely
related factors. Comparisons of a company in relation to a well
defined peer group can provide valuable insights into the company’s
performance an its relative valuation.

A peer group should consist of firms that are alike in their principal lines of business, along with other similarities such as cost structures and access to capital. Firms can be similar in business cycle sensitivity but dissimilar in terms of their business activities (e.g., a firm in the home building industry and a firm in the heavy equipment manufacturing industry).

For relative valuation, a peer group is best described as companies:

with similar business activities and competitive factors.

An analyst should form peer groups of companies that have similar business activities, drivers of demand and costs, and access to capital. Companies in the same industry or sector and companies at the same stage of the industry life cycle are not necessarily comparable for equity valuation purposes.

Question 2

Steps to form a peer group:

Answer 2

– Use commercial classification providers
– Examine subjects' annual reports
– Examine competitors' annual reports
– Use industry trade publications
– Confirm comparable firms

Adjust financial statements for possible unrelated activities

Question 3

Questions that may improve the list of peer companies:

Answer 3

What proportion of revenue and operating profit is derived
from business activities similar to those of the subject
company? ….. In general, a higher percentage results in a
more meaningful comparison.
Does a potential peer company face a demand environment
similar to that of the subject company?
Does a potential peer company have a finance subsidiary?