For the Analyst: Peer Benchmarking Methods to Improve Earnings Forecasts

Discovering appropriate friends for monetary evaluation is a vexing activity that requires cautious consideration of corporations’ underlying economics, accounting decisions, and monetary assertion presentation. However with out comparable monetary assertion info, peer benchmarking could yield much less significant and even deceptive insights that negatively influence earnings forecasts.

In a recent study revealed in The Accounting Evaluate, we developed a strategy to determine comparable corporations for benchmarking and analyzed its implications for analyst outcomes and valuation with multiples. On this submit, we are going to spotlight the salient particulars, a few of which can shock you.

There are alternative ways to outline peer corporations, akin to industry membership, stock index membership, closeness in market capitalization, and similarity in value drivers (e.g., P/E ratio, return-on-invested capital, and progress).

As a substitute for conventional classifications, researchers have examined new methods to determine peer corporations, akin to buyers’ co-search, depth of corporations’ filings with the SEC’s EDGAR, and inventory info on Yahoo! Finance.

These extensively utilized strategies fail to instantly handle an important facet of agency benchmarking: the provision of key monetary assertion info for peer corporations. When a number of monetary assertion line objects are lacking for a peer agency, analysts battle to derive significant inferences from the comparative to the focal agency’s monetary statements.

Our monetary assertion benchmarking (FSB) measure goals to fill this hole. The information and code are freely accessible on our website.

Capturing the Diploma of Overlap Between Monetary Assertion Objects

Constructed on the Jaccard similarity coefficient, pairwise FSB captures the diploma of overlap in monetary assertion objects reported by two corporations, with scores starting from 0 (no overlap) to 1 (full overlap). The upper the FSB rating, the higher the benchmarking info accessible to exterior customers.

As an example, if the focal agency has reported 270 objects, 200 of which overlap with 220 objects reported by the peer agency, the FSB rating is 0.69 (200 / (270 + 220 – 200). To place this into context, the common rating for analyst-chosen friends in our pattern is 0.68.

Assuming that FSB is a useful metric in capturing the similarity of two corporations’ underlying economics and accounting decisions, we anticipate it to be positively correlated with analysts’ decisions of peer corporations.

Our pattern of analyst-chosen friends comes from a Evaluate of Accounting Research article, “Analysts’ choice of peer companies.” By manually screening greater than 2,500 sell-side fairness analysts’ studies, the authors extracted knowledge on comparable peer corporations chosen for the focal agency in every report.

In our examine, for every analyst-chosen peer agency, we chosen an identical agency in the identical {industry} that was not chosen however which had the same dimension and valuation a number of. The outcomes present that analysts have a tendency to decide on peer corporations which are extra corresponding to a focal agency from a monetary assertion benchmarking perspective.

When FSB is greater by one-standard-deviation, the probability of being chosen as a peer agency by an analyst will increase by 13%.

Larger FSBs Improve Accuracy of Earnings Forecasts

Does selecting friends with greater FSBs have constructive implications for analyst efficiency? We discover that when the common FSB of the set of analyst-chosen peer corporations is one-standard-deviation greater, the accuracy of analysts’ earnings forecasts will increase by about 23%.

When choosing peer corporations, search for corporations which have extra comparable monetary statements to the focal agency, even when which means looking exterior the focal agency’s major {industry}. In truth, solely 40% of the analyst-chosen peer corporations function in the identical product market because the focal agency.

Which firms do you assume could be good peer corporations to decide on when analyzing Colgate-Palmolive? Morningstar lists Procter & Gamble and Unilever as high friends for the corporate. Regardless of being listed on a US inventory trade, Unilever has a modest 0.69 FSB rating with Colgate-Palmolive.

That is probably as a result of the corporate makes use of Worldwide Monetary Reporting Requirements to arrange its monetary statements. Utilizing completely different accounting requirements reduces comparability resulting from variations within the recognition and presentation guidelines. In distinction, P&G and Colgate-Palmolive have a better FSB rating of 0.77, suggesting a higher comparability than Unilever and Colgate-Palmolive.

In distinction to Morningstar’s strategy, Google Finance creates a listing of peer corporations primarily based on buyers’ co-search exercise. Notably, among the many peer corporations Google Finance lists for Colgate-Palmolive is Coca-Cola. Though this statement could seem unintuitive at first blush, our methodology means that, from a monetary assertion benchmarking perspective, Coca-Cola could be a wonderful match on this case as a result of its FSB rating with Colgate-Palmolive is effectively above the common at 0.82. This will likely clarify why buyers extensively co-search the monetary info of the 2 firms.

Validation and Testing

After validating and testing the pairwise FSB metric, we aggregated knowledge throughout all {industry} friends of the focal agency to grasp how simple it’s to benchmark a agency’s monetary statements general. This course of yielded a big panel of firm-level FSB knowledge. Additionally, to counterpoint our methodology, we decomposed FSB on the monetary assertion stage, producing separate FSB scores for the revenue assertion, stability sheet, and assertion of money flows.

Whereas analysts’ consensus earnings and web debt forecasts are extra correct when firm-level FSB is excessive (i.e., it’s simple to benchmark and perceive a agency’s monetary statements), revenue assertion and stability sheet benchmarking play completely different roles in these outcomes.

We discover that the Earnings assertion FSB rating predicts the accuracy of earnings forecasts however not web debt forecasts. In distinction, stability sheet FSB rating predicts the accuracy of web debt forecasts, however not earnings forecasts. In financial phrases, a one-standard-deviation improve in revenue assertion (stability sheet) FSB is related to a 17.3% (12.1%) extra correct consensus earnings (web debt) forecasts. These findings spotlight that benchmarking advantages rely upon the context of the evaluation. 

For the Investor: Business, Business-Measurement, or FSB Friends

Past constructive analyst outcomes, a key query for buyers is whether or not selecting peer corporations primarily based on FSB improves valuation with comparables. To this finish, we in contrast the predictive potential of the valuation multiples fashioned utilizing FSB-based friends to these of the fashions using conventional strategies for peer agency choice, akin to industry- and size-based friends. Particularly, we regressed the long run enterprise value-to-sales ratio (EVS) of the focal agency on the common EVS calculated for 3 units of friends: (1) {industry} friends, (2) industry-size friends, and (3) FSB friends. 

When predicting one-year, two-year, and three-year-ahead EVS, the fashions utilizing the common valuation a number of of FSB-based friends persistently outperform these using solely industry- and industry-size friends. As an example, the R-squared of the mannequin predicting one-year-ahead EVS will increase from 24.8% to 31.8% when the common EVS of the 4 highest FSB friends is included within the mannequin.

In conclusion, we notice that FSB is an easy, easy measure summarizing the overlap in peer corporations’ underlying economics and accounting decisions, that are the important thing elements that form monetary statements. FSB is out there on the pairwise and agency ranges, permitting exterior customers to search out appropriate peer corporations for varied functions, together with relative efficiency, compensation, and valuation benchmarking.