Comparisons aren't used in financial analysis

SRI analysts are surrounded by comparisons and constantly hear financial analysts say “I’m recommending Company A; on my numbers, it’s looking cheap on a P/E of 8x against Company B on 9x.”

However, if we expand our fictional financial analyst’s summary statement out into its full version, we find the comparison between Company A and Company B is little more than a post-hoc sense-check and a marketing motif.  The fundamental research process involves very little comparison between Company A and Company B.

In full, the analyst is actually saying:

• I have developed a model that records the revenues, costs, margins, tax payments, assets, liabilities, cashflow etc. of Company A stretching back over 5+ years.
• I have forecast, from bottom up:
  • explicitly, how these are likely to change over the next five years
  • implicitly, how these are likely to change over the next ten to twenty years
• (Most frequently) I have discounted Company A’s future cash flow back to the current date and find that this gives me a valuation for the asset
• I find that this ‘target price’ is below price at which Company A’s stock is currently trading in the market
• I have reviewed the likely risks and opportunities facing Company A and have identified catalysts that will emerge over the next 12 months and force the market to a more accurate appreciation of its fundamental value
• I have conducted the same fundamental analysis process on Company B
• On the basis of these two analyses, I have concluded that Company A is better value than Company B
• As a simple indication of this, I note how the ratio between next year’s forecast earnings and the price is superior for Company A

The P/E relative is simply a post hoc sanity check – the vast majority of the analysis and argument are based on expectations for Company A developed in isolation.

Bond markets

Similarly, in bond markets, the rating represents the absolute likelihood of default – not a likelihood relative to other stocks in the sector.

Although comparison can be drawn between bonds after the research has been completed, comparison is not part of the research process.

Mike 

Although comparison can be drawn between bonds after the research has been completed, comparison is not part of the research process.  Accordingly, no credible parallel can be sustained between bond ratings and SRI research for ‘best-in-class’ funds.  See also: SRI ratings - debt market tools for an equity world.

Qualifiers

The arguments above are qualified (but not negated) by the following:

• It is likely that inputs to the analysis model are the same for companies in the same sector (e.g. US healthcare spending for pharma companies)
• It may be that companies compete directly and have complementary market share
• It is likely that the analyst considers (and compares) all companies in a sector when deciding which valuation techniques to use
• Comparison, of course, plays a more significant role in the portfolio management process (as opposed to the analytical process).  However, it is important to remember that the comparisons made by portfolio managers are entirely contingent upon the fundamental analysis having been conducted earlier in the process

Comparisons by sustainability analysts

Given how hard it is to compare the sustainability performance of companies and the absence of a mainstream parallel, I have to ask:

• Why do SRI analysts ever try to compare the sustainability performance of companies?
• Why do companies respond to this by contorting their sustainability performance data into shapes that can't realistically be used to make investment decisions?
• Why do we waste so much time trying to systematise data when it is the idiosyncratic data that gives rise insight into disruption and enables investment performance in this space?