Peer Group Valuation Is (Mostly) Useless

A company’s value is its future free cash flow discounted back to the present. I doubt any readers will argue with me there. And when you break it down, the two things that determine future cash flow are return on invested capital (ROIC) and growth. So if ROIC and growth are the two determinates of future value, then to have a fair peer analysis the included companies should have similar returns on capital and growth prospects. If two companies have different ROICs or growth prospects then it’s not an apples-to-apples comparison.

Having similar growth potential also insinuates the two companies are in the same stage of their life cycle, meaning they’re similar sizes. So including mature businesses in a peer valuation for a small-cap company is meaningless. When a company is selling for less than its peers, it’s almost always because it has lower returns on capital or its growth prospects are not as good as its competitors. There are a few other factors that play into this as well.
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LGI Homes (LGIH)

LGI Homes (LGIH, $16.69) is a little known homebuilder that is a good example of the baby being thrown out with the bathwater. LGI derives around 60% of its revenue from Texas and anything related to oil has been crushed in the past nine months. Since touching $21 last July, LGI is down 20% despite great results and very positive guidance for 2015. Homebuilding is a fairly crappy industry (commodity, high debt loads and heavily dependent on the economy) but LGI is both one of the fastest growing and cheapest homebuilders out there. LGI is in a great position to soar over the next few years as the housing recovery continues and mortgages are easier to get.

Business overview
LGI was founded in 2003 and IPOed in November of 2013 so they just released their first full year of results being a public company. They specialize in building move-in ready homes for first-time buyers (mainly young renters looking to buy) and their average sales price is $166k which is substantially less than the next closest public homebuilder (AVHI in the $250s). Maintaining a growing inventory of move-in ready homes is, in my eyes, much riskier than many builders that only construct homes after receipt of a signed contract and deposit. In good times (like right now) they are able to immediately sell homes though, so it cuts both ways.
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