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.
Continue reading “Peer Group Valuation Is (Mostly) Useless”
