| Leverage and Profitability Ratios | ||||||||
|---|---|---|---|---|---|---|---|---|
| Name | Ticker | ROE | ROA | Gross Margin | Operating Margin | Profit Margin | Debt/ Equity | Expected Annual Earnings Growth |
| McDonald's Corp. | MCD | 302% | 9% | 51% | 38% | 25% | 0.2 | 18% |
| Yum! Brands Inc. | YUM | n/a | 15% | 48% | 29% | 16% | 0.3 | 13% |
| Wendy's International Inc. | WEN | 24% | 2% | 36% | 17% | 7% | 0.5 | 15% |
| Average | -- | 163% | 9% | 45% | 28% | 16% | 0.3 | 15% |
In Figure 2, we see that metrics for quick-service restaurants vary considerably. A higher ROE, ROA, gross margin, operating margin and profit margin indicate better efficiency and/or operating conditions, which will 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, Chipotle, 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 Figure 1). Expected earnings growth is the only metric in the above table that cannot be calculated from the companies' financial statements.
In Figure 2, this earnings growth figure is taken from consensus analyst estimates. Although it is possible for individual investors to model earnings growth themselves, great care should be taken to keep estimates reasonable because this variable can affect valuation significantly.
Spotting Undervalued Stocks
The next step is to use these metrics in conjunction with current valuation ratios to spot undervalued stocks. To do this, analyze the leverage, profitability, and other relevant metrics to try to determine which companies should carry a higher-than-average valuation, then compare those predictions with current actual valuations. If the current valuation is lower than seems reasonable based on this analysis, then the security may present a buying opportunity.
However, this is rarely as easy as it may seem. While some investors use quantitative econometric analysis to try 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. Additionally, qualitative factors must also be taken into account.
Qualitative Factors
Some companies have advantages or disadvantages relative to their peers based on factors not found in their financial statements. Management quality is one of the most widely studied qualitative factors because 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. Some factors focus on minimizing risks faced by investors; for example, corporate governance measures are designed to ensure that shareholders' rights are upheld.
Another very popular way to look at qualitative aspects 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
- Competitive landscape within the firm's industry.
The interaction of these five forces can affect a firm's long-term prospects for continued success.
Like leverage and profitability metrics, qualitative factors should be analyzed to determine whether a company is in a better or worse position than its peers, and thus should be valued at a higher or lower multiple. If the current valuation is lower than seems reasonable after taking all of these metrics and qualitative factors into account, then the stock may be undervalued.
Peer Comparison vs. Discount Cash Flow Analysis
While we will not discuss discounted cash flow (DCF) analysis in depth here, there is one key difference between peer comparison and DCF valuation methods that should be noted. Peer comparison analysis assumes that the peer group is, on average, fairly valued. If this does not hold true, the entire industry may rise or fall and take every stock with it.
In 2000, an investor using peer comparison to analyze the internet industry might have found a stock with potential to outperform its peers, but the flaw in this logic would have been that its entire peer group was overvalued and fell dramatically over the next couple of years. Any security that was selected at the time as the most attractive would probably still fall because the industry was revalued at a lower overall valuation.
Discounted cash flow, if accurately implemented, is not subject to this problem. Because DCF does not depend on how a firm is valued relative to others, this method can, theoretically, value a firm without regard to the value of its peers, or even the overall market. Both methods, however, do involve a great deal of judgment and discretion, and must be conducted with care in order to achieve valid results.
The Bottom Line
Peer comparison analysis is one of the most useful tools for an equity analyst or individual investor. Because the data necessary to conduct the analysis is generally public and readily accessible on financial websites, it is easy for anybody to begin employing this method of analysis.
