What Is a Peer Group?
A peer group is a group of individuals or entities that share similar characteristics and interests among one another. Peer groups, in the case of people, have characteristics that include similarities like socio-economic status, level of education, ethnic background, and so on among its individual members. In the context of firms, a peer group refers to companies that are competitors in the same industry sector and are of similar size.
- A peer group refers to like individuals or organizations that share several similarities, making them easily comparable as a group.
- Individual peer groups include people that share similar characteristics like income, geographic location, age, or race.
- Firm peer groups include companies in the same industry sector or competitors and can be used for peer analysis.
Understanding Peer Groups
In investment research, peer group analysis is a vital part of establishing a valuation for a particular stock. The emphasis here is on comparing "apples to apples," which means that the constituents of the peer group should be more or less similar to the company being researched, particularly in terms of their main areas of business and market capitalization.
Peer group analysis can enable investors to spot valuation anomalies for a specific stock. For example, a stock that is trading at an earnings multiple of 15x – compared with an average multiple of 10x for its peer group – could justifiably be considered overvalued. Alternatively, investors can uncover the potential reasons for the higher earnings multiple and ultimately determine that it is deserved.
If not immediately obvious, peer groups are sometimes identified by a given company in its 10-K filing and almost always in its proxy filing (Form DEF14A), though the latter can be more expansive in terms of specific business sectors and is used to set executive compensation plans. Lockheed Martin, for example, lists General Dynamics, Raytheon and Northrup Grumman as peers; it also lists Caterpillar, United Parcel Service and 3M.
Insurance companies also compile peer groups in order to underwrite life or health insurance policies on certain demographic portions of a population, for instance peer groups by age or whether or not they smoke.
Using Peer Groups
Peer comparison is one of the most widely used and accepted methods of equity analysis used by professional analysts and by individual investors. Because companies in a peer group share similar traits, such as industry sector or size, it lends itself to relative value analysis. Relative valuation among peers in a group has proven to be efficient and effective, quickly showing which stocks may be overvalued, and which might make good additions to a portfolio. While there are other methods of determining when a stock is worth buying, such as discounted cash flow or technical analysis, peer comparison analysis remains a key tool for uncovering undervalued stocks.
Because the data necessary to conduct the analysis is generally public and readily accessible on financial websites, it is easy for anybody to begin employing this method of analysis in order to identify opportunities.