Caution with Comparables

Comparables or Ratios are a very common approach you would come across in most stock research reports but when you tend to take a judgment based on these, you most of the times would be mislead. Brokers in general belong to 2 categories i.e. Private Brokers and Business Brokers. Private Brokers invest their own money and trade in the markets based on their own analysis and interpretation. Business Brokers on the other hand trade with their own money as well as act as intermediary brokers for retail customers.

The problem with comparables is that they tend to take industry averages as a benchmark for measure of success and more often than not, tend to club all companies belonging to an industry under the same bucket. So technically you might be comparing a company with a Rs 200 crore turnover with one that has a Rs 2000 crore turnover. So would the result be unbiased? of course not. When I spoke to a few Private Brokers I know, they told me that they do use comparables and valuation models but tweak them as per personal judgement. So they would ideally make three baskets of Large, Medium and Small sized companies and use comparables in appropriate baskets, thus having a rationally more sound outcome.

This might sound stupid, but it is a very common mistake made while using Financial Ratios. So the next time you use ratios, make sure that the averages you use belong to the same category of companies.