Comparing peers and finding candidates

Estimating a full intrinsic value, as the last chapter did, is careful work, and its answer is only ever a rough range. So in practice most investors lean heavily on a faster method: judging a company by comparison, against businesses like it and against its own past. It is quicker and genuinely useful, and it is also where a careless investor is most easily led astray, so it is worth doing properly.

Valuing by comparison

Relative valuation judges whether a company is cheap or dear by comparing its ratios, the P/E, EV/EBITDA, P/B, and the rest, with those of two reference points: its close peers, and its own history. This is the discipline from the valuation-ratios chapter, now put to work. A P/E of 20 tells you nothing alone, but placed beside its peers it starts to speak.

Suppose three similar companies in an industry trade at P/E ratios of 15, 20, and 30, with an average near 22, and the company you are studying is the one at 20, sitting mid-pack. That comparison does not give you an answer, but it gives you the right question: why is this one cheaper than the company at 30, and dearer than the one at 15? Perhaps it grows slower, carries more debt, or has a weaker moat, all of which you can now judge from the earlier parts, or perhaps the market has simply overlooked it. Relative valuation raises the question; your qualitative work answers it. Comparing a company with its own history works the same way: a business trading well below the multiple it has usually commanded is worth a look, as long as you can explain why the discount is temporary rather than deserved.

Screening to find candidates

There are thousands of listed companies in India, far too many to study one by one, so investors use a stock screen to narrow the field. A screen filters the whole market down to the handful that meet criteria you set, letting you turn a mass of companies into a short, workable list.

Sensible screens combine the ideas of this course. You might ask for companies with a return on capital above 20%, debt-to-equity below 1, several years of steady profit growth, and a reasonable valuation, each filter drawn from a chapter you have read. The screen then hands you a shortlist of businesses that, on the numbers, are worth a closer look. In India, screening tools that pull the exchange-filed financials are widely available, and building a screen from your own criteria is one of the most useful habits an investor can form.

A screen finds numbers, not businesses

Now the essential warning, without which screening does more harm than good. A screen finds numbers, not businesses. It can tell you a company has a low P/E and a high past return, but it cannot see the moat, judge the promoter, read the related-party transactions, or know that the industry is about to turn. Everything qualitative, everything from Part 4, is invisible to it.

So a screen is the start of research, never the end. Its output is a watchlist of candidates to investigate with the full toolkit of this course, not a buy list. Many a cheap-looking screen result is a value trap, the subject of the next chapter, cheap precisely because the business is deteriorating in ways no filter can capture. Treat the screen as a way to decide what to study, and then do the studying.

One more caution applies to relative valuation itself. Comparing a company with its peers only helps if the peers are sensibly priced, and sometimes a whole sector is swept up in enthusiasm and every company in it is expensive together. A stock that looks cheap against wildly overpriced peers is not cheap; it is merely less overpriced. Relative valuation tells you how a company is priced against others, not whether that whole group is priced sensibly, which is exactly what an intrinsic-value estimate, and a margin of safety, are for.

What to carry forward

In practice you value most companies by comparison, against their peers and their own past, and you find candidates by screening the market down to those that meet your criteria. Both are genuinely useful and both mislead if trusted blindly: a screen surfaces numbers but is blind to everything qualitative, so it only ever produces a watchlist to research, and relative valuation is only as sound as the peers you compare against. Use them to decide what to study, then study it with the whole course.

Both routes, relative and intrinsic, can still lead a careless investor into the most common and painful error in value investing: buying something cheap that keeps getting cheaper. The next chapter is about value traps and the recurring mistakes that catch fundamental investors.