When it comes to financial analysis, finding suitable peers for benchmarking can be a challenging task. Without comparable financial statement information, the insights gained from peer benchmarking may be less meaningful and even misleading, leading to inaccurate earnings forecasts.
A recent study published in The Accounting Review explores a new methodology for identifying comparable firms for benchmarking purposes and its impact on analyst outcomes and valuation using multiples. In this blog post, we will delve into the key details of the study that may surprise you.
There are various ways to define peer firms, including industry membership, stock index membership, market capitalization proximity, and similarity in value drivers like P/E ratio and return on invested capital. Traditional methods and newer approaches like investors’ co-search and firms’ SEC filing intensity have been explored to identify peer firms for benchmarking.
However, the key challenge lies in the availability of key financial statement information for peer firms. This is where the financial statement benchmarking (FSB) measure comes into play. FSB aims to address the gap by capturing the overlap in financial statement items reported by two firms, providing crucial benchmarking information.
Capturing Similarity in Financial Statements
The FSB score ranges from 0 (no overlap) to 1 (full overlap), indicating the degree of similarity between firms’ financial statements. Higher FSB scores suggest greater benchmarking information availability. Research has shown that FSB is positively correlated with analysts’ choices of peer firms, leading to more accurate earnings forecasts.
Analyst-chosen peer firms that align closely with the focal firm in terms of financial statement benchmarking tend to result in more accurate earnings forecasts. In fact, analysts’ consensus earnings forecasts become 23% more accurate when the average FSB of peer firms is one-standard-deviation higher.
Choosing the Right Peer Firms
When selecting peer firms, prioritizing those with similar financial statements to the focal firm can enhance the accuracy of earnings forecasts. Look beyond industry boundaries and consider firms with high FSB scores, even if they operate in different sectors.
For example, when analyzing Colgate-Palmolive, peer firms like Procter & Gamble and Unilever are commonly suggested. While Unilever may have a modest FSB score with Colgate-Palmolive due to differing accounting standards, firms like P&G show higher FSB scores, indicating better comparability.
Validation and Implications
Validating the pairwise FSB metric has shown that income statement FSB scores predict earnings forecast accuracy, while balance sheet FSB scores predict net debt forecast accuracy. Understanding the role of different FSB scores in financial analysis can enhance forecasting precision.
Furthermore, using FSB-based peers for valuation purposes has proven to outperform traditional industry-based peer selection methods. Models incorporating FSB-based peer data lead to more accurate valuation multiples, offering investors a better understanding of a firm’s financial standing.
In conclusion, FSB provides a valuable measure for assessing the similarity in firms’ underlying economics and accounting choices, essential for effective financial statement benchmarking. By leveraging FSB data at both pairwise and firm levels, analysts and investors can make more informed decisions when selecting peer firms for benchmarking purposes.