A company can frequently be valued by comparing it to a peer group of companies. The advantage of performing a peer group comparison is that the constituent companies are normally fairly similar along their product/service lines, sizes and operating structures. This approach assigns company “value” based on the notion that assets of similar dimensions should sell at similar prices and is known as the “method of comparables.”
The method of comparables involves taking a subject company’s P/E, P/B, P/S, P/CF or some other multiplier and then comparing it to the mean or median multiplier for the peer group to derive a relative value. This equilibrium multiplier can then be multiplied to the subject companies per share earnings, book value, sales or cash flows to derive a fair-value estimate. The stock’s market price could then be compared against this fair value estimate to determine whether the position is under- or overvalued.
For the purpose of this article we are going to use the method of comparables to assess Home Depot (HD, Financial), the U.S.’ largest retail supplier of home repair, building and maintenance materials. The valuation metric we will use is the trailing 12-month P/E. We will evaluate the P/E using the mean P/E for its peer group companies as the benchmark value. Trailing P/Es for its peer group are presented in the table below.
Table: Trailing P/Es of Home Depot and Peer Group
| Company | Trailing P/E |
| Home Depot (HD, Financial) | 23.4 |
| Lowe’s (LOW, Financial) | 23.4 |
| RONA (RON, Financial) | 27.0 |
| Canadian Tire (CTC.A, Financial) | 15.8 |
| Wolseley (WOSCF, Financial) | 21.3 |
| Lumber Liquidators Holdings (LL, Financial) | 22.6 |
| Mean | 22.3 |
From the table above it is clear that the mean trailing P/E for the group is 22.3 and, as such, 22.3 represents the benchmark value for the multiple.
Assuming no differences in the fundamentals among peer group companies, it is possible to determine whether HD is relatively fairly valued, relatively overvalued or relatively undervalued by comparing HD’s market multiple to the benchmark value. HD appears to be slightly overvalued because its P/E of 23.4 is greater than the mean of 22.3.
Based on the data in the table, it is also possible to determine which stocks appear to be relatively undervalued. Both Canadian Tire (CTC.A, Financial) and Wolseley (WOSCF, Financial) appear to be undervalued relative to their peers because their trailing P/Es are lower than the mean P/E of 22.3.
Before drawing any solid conclusions, however, further analysis should be conducted to confirm whether the apparent differences in valuation can be explained by differences in other fundamental factors, such as differences in risk and expected growth rates. In addition, financial analysis must be conducted to try to determine any basis by which companies differ that could justify trading at an above average or below average multiple. From this exercise it is not possible to say confidently that CTC.A and WOSCF are buys, but it is possible to say with confidence that they at least deserve a deeper look.
