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How to Compare Stocks of the Same Sector or Industries?

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Synopsis:

Whether you are just beginning to invest or are a seasoned investor, you must understand how to compare stocks from the same industry thoroughly. Such comparisons help you identify over and undervalued stocks. They also let you identify red flags in a company. Hence, they are invaluable for an investor. Typically, for stock comparison, ratios and parameters are used, which may vary from sector to sector. For example, non-performing assets are extremely important in the banking sector because banks provide loans and some of these loans end up being non-performing. However, this parameter is not important in the manufacturing sector. Hence, before you start comparison, understand which ratios are important. While stock comparison can provide compelling insights, an incorrectly performed comparison can be counter-productive as well. So, always be careful.

How to Compare Stocks of the Same Sector or Industries

Comparing stocks from the same sector or industry often reveals compelling insights about a stock’s performance. However, to compare stocks, we should use the correct parameters or ratios.

For example, in the case of the manufacturing sector, we should compare the Return on Equity (RoE) and Return on Capital Employed (RoCE) across firms. However, in the banking sector, we should compare Net Interest Margin (NIM), Net Non-Performing Assets (NPAs), and Return on Assets (RoA) across banks. These ratios or parameters depend upon the nature of a firm's business.

Read this blog, as it explains in detail how to compare stocks, what factors to keep in mind, and which mistakes to avoid.

Understanding Stock Comparison

Before we start understanding how to compare stocks, let’s discuss why we compare them in the first place. We compare a stock with others from its industry to examine how it is performing vis-à-vis others. It helps us find whether a stock is under or overvalued.

Stock comparisons are a great thing to do, but they can be a bit tricky. Let’s talk about the banking sector. Can we compare HDFC Bank with Yes Bank? The answer is no because HDFC Bank is a much bigger bank than Yes Bank.

As per its annual report, the balance sheet size of HDFC Bank as of March 31, 2024, was Rs. 40,30,194 crores. However, the balance sheet size of Yes Bank was Rs. 4,05,493 crores. This shows that Yes Bank is a tiny bank compared to HDFC Bank.

While comparing stocks, we should also examine whether they belong to companies that are in similar business. If two companies are not in similar business, we shouldn’t compare them. For example, a bank focusing aggressively on corporate loans shouldn’t be compared with another focusing on retail loans because the characteristics of these two categories of loans are different.

Key Metrics for Comparing Stocks

Find below the key metrics that you should consider while comparing stocks:

  1. Market capitalisation: This metric is calculated by multiplying the outstanding shares of a company with its stock’s market price. The larger the market cap, the bigger the company.

  2. Price-to-earnings (P/E) ratio: By dividing a company’s stock price by its net profit per share, we can find the P/E ratio. This tells us how much we are paying for a stock for every rupee of net profit it generates. If a company has a significantly higher P/E ratio than its peers, it shows that its stock is more expensive than its rivals.

  3. Debt-to-equity (D/E) ratio: This is a ratio of what a company owes to others to its own funds. If a company owes a lot, it means it needs to have significant cash flows to pay interest and principal on such debt. However, if a company does not have a lot of debt, it means it doesn’t owe much to outsiders.

Analysing Company Performance

Analysing a company’s performance is at the heart of stock comparison. If you cannot analyse a company’s performance well, you can’t compare it with its rivals. So, how should we go about it?

The first thing you should analyse is how well a company is selling its products. For this, you should check its sales growth. Then, you need to see whether it is managing its operations well. A company can have high sales growth by paying extremely high salaries to its employees. Therefore, you should check its profit growth.

Then, you should check how well a company is generating cash flows. If a company is not generating sufficient cash flows, its very existence can be threatened. For this, you should see how its free cash flows are growing.

Valuation Techniques for Sector Stocks

We need to compare the valuation of a stock with that of other stocks in its industry. For this, we can compare the price-to-earning (P/E) multiple across stocks. This is arrived at by dividing the price of stock by its earnings per share. It tells us how much we are paying for every rupee in net profit generated by a company.

If a stock has a higher P/E than its rivals, it can be said that it’s more expensive than its competitors.

Price-to-book value (P/B) (or price per share divided by book value per share) is another ratio that you can consider while comparing two stocks in the same sector. A company’s book value is calculated by deducting external liabilities from its total assets. This ratio tells us how much we are paying for every rupee of book value in a firm.

Understanding Industry Trends and Economic Factors

While comparing stocks in the same industry, it’s extremely important to understand industry trends and economic factors. Let’s say that you are analysing the performance of an IT company and you find that this company’s sales have grown at a lower than the pan-industry sales.

In this case, you should figure out why this company has underperformed. If its low sales growth is not backed by a justifiable reason, then its stock price is likely to fall. Similarly, economic factors play an important role. It's relatively easier for companies to grow their business when an economy is expanding, and vice versa. Hence, you should always check GDP growth, interest rates, and inflation in an economy while comparing stocks in the same sector.

Why is it Important To Compare A Stock With Its Peers?

Here’s why it’s important to compare a stock with its peers:

  1. When we compare a stock with its peers, it becomes easy to identify over and undervalued stocks.

  2. It helps us analyse how a company is performing compared to its peers. For example, if we only consider a company’s sales growth, it won’t tell us much about its performance. But, if we compare its sales growth with that of its peers, we can figure out whether it is over or underperforming.

  3. It can help us identify red flags in a company. Suppose a firm is increasing its debt every year, while none of its competitors is doing so, then you should ask why it is taking debt. It could be that this company is not able to generate sufficient cash to pay its debt. Such factors are always worth looking into.

Tools and Resources for Stock Comparison

Several tools and resources are available in India for stock comparison. Prominent ones are listed below:

  1. National Stock Exchange’s (NSE) and Bombay Stock Exchange’s (BSE) websites: The websites of these two stock exchanges provide the data about financials of companies, stock prices, volume, and many other parameters.

  2. Bloomberg India: This database provides a lot of information, including current stock prices, news, and even ratio analysis of companies. It can help you get tons of information related to a company’s financial performance and its stock price.

  3. Capitaline: This database provides information about current and historical financial performance of companies. If you want to find a company’s current and historical income statements and balance sheets, it’s a great resource.

Conclusion 

If you are on the verge of opening a demat account online, you must understand how to compare stocks with each other. Such comparison is invaluable to identify over and undervalued stocks. Hence, it can help you decide which stocks to buy and which ones to sell. That said, if you do not perform the comparison carefully, then it can defeat the purpose as well. Hence, you should always compare similar companies. Remember the old adage. Compare apples with apples, not with oranges.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

Why is it important to compare a stock with its peers?

Answer Field

We can find over and undervalued stocks by comparing price-to-earnings and price-to-book value ratios across stocks in the same industry. A comparison also lets us identify red flags in a company’s performance.

How do I evaluate the growth potential of stocks in a specific industry?

Answer Field

First, you should analyse the financial performance of a company. If a company is not performing well, its stock price is unlikely to increase. Then, you should compare the valuation of a stock with that of its peers.

How can I use financial ratios to compare companies in the same sector?

Answer Field

You should figure out the ratios relevant to a sector. For example, in the banking sector, ratios like Net NPA, Net Interest Margin (NIM), Return on Assets (RoA), etc. are important. But, in the manufacturing sector, Return on Capital Employed (ROCE), Return on Equity (ROE), and working capital ratios are important.

What are the risks of comparing stocks in the same industry?

Answer Field

When comparisons are not done correctly, they can result in misleading insights. And, making any decision based on such analysis can be extremely risky.

How important is management quality when comparing stocks in the same sector?

Answer Field

Management quality is extremely important while comparing stocks. It tells us the vision of the management, which drives a company’s performance. It also tells us whether a company is achieving the targets set by its management or not.

How can I use industry benchmarks to compare stocks effectively?

Answer Field

Industry benchmarks help us understand whether a company is over or under-performing compared to its industry. For example, in the banking sector, a NIM of 3% is considered acceptable. While comparing banking stocks, we can examine whether a bank is achieving this benchmark or not.

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