Benchmarking in finance

Benchmarking is widely recognized as a favored method for conducting fundamental analysis.

What is benchmarking?

Benchmarking in finance refers to the process of comparing the financial performance, metrics, or characteristics of a company or investment against a predefined benchmark. The benchmark serves as a standard or reference point against which the financial performance of a company or investment is evaluated.

In finance, benchmarking is commonly used in various areas, including investment management, portfolio analysis, and performance evaluation. The benchmark can be an index, such as the S&P 500 for the overall stock market, or a specific index representing a particular sector or asset class.

The purpose of benchmarking in finance is to assess how well a company or investment is performing relative to its peers or the broader market. By comparing financial ratios, key performance indicators, or other relevant metrics to the benchmark, analysts and investors can gain insights into the relative strengths, weaknesses, and opportunities for improvement.

For example, in investment management, benchmarking is used to evaluate the performance of a portfolio or investment strategy against a designated benchmark. If a portfolio outperforms the benchmark, it indicates that the portfolio manager has generated above-average returns. On the other hand, underperformance against the benchmark may prompt a reevaluation of the investment approach or asset allocation.

Benchmarking also helps investors and analysts identify investment opportunities and trends. By comparing financial metrics of different companies within the same industry or sector to a benchmark, they can identify undervalued or overvalued stocks and make more informed investment decisions.

Overall, benchmarking in finance provides a standardized way to measure and evaluate the financial performance of companies, investments, or portfolios. It enables comparisons, identifies areas for improvement, and assists in making informed financial decisions based on relative performance.

Example:

Let’s look at banking sector.

Prominent institutions such as big banks, portfolio managers, fund managers, and mutual funds typically possess a prospectus. This document outlines the guidelines and restrictions governing how they can invest their clients’ funds. Within the prospectus, specific allocations are designated for various sectors. For instance, it might specify a 30% allocation to the financial sector, 20% to the technology sector, and 10% to bonds. Regardless of the sector, these institutions are bound by their prospectus, which outlines the permitted amount of funds that can be allocated to each sector.

Within this prospectus framework, the portfolio manager is responsible for overseeing a team of analysts. The primary role of these analysts is to identify banking companies that are expected to perform exceptionally. Suppose they are examining Bank of America (BAC), Citigroup (C), Royal Bank, and TD. Their objective is to locate companies that they deem undervalued and likely to experience significant appreciation over time. To achieve this, they employ the method of benchmarking.

The analysts will conduct a thorough comparison among the companies. For instance, they will assess the price-to-earnings (P/E) ratios: BAC has a P/E ratio of 12, Citigroup has a P/E ratio of 15, TD has a P/E ratio of 28, and Royal Bank has a P/E ratio of 14. Additionally, they will evaluate dividend yields, where BAC offers 4% dividends, Citigroup and TD do not provide dividends, and Royal Bank offers a dividend yield of 3%. They will also consider other vital ratios specific to the banking sector. Through this analysis, their aim is to identify the most undervalued stock among the options.

P/EDIVIDEND %
BAC124%
C150
RY143%
TD280

If these were the only available ratios, the analysts would likely consider Bank of America as the top investment choice since investors are paying only $12 for each dollar the company generates. Consequently, they would include Bank of America in their portfolio due to its perceived undervaluation.

However, over time, let’s say after a year, the new P/E ratios are as follows: BAC rises to 20, Citigroup declines to 13, Royal Bank increases to 18, and TD climbs to 22. In this scenario, Bank of America appears to be priced relatively high, as investors are now paying $20 for every dollar the company earns. Upon receiving this information from the analysts, the portfolio manager will decide to sell Bank of America in their portfolio. Conversely, they would recognize Citigroup as an attractive opportunity to buy since investors would only be paying 13 times the company’s earnings, indicating a more favorable valuation.

P/EDIVIDEND %
BAC204%
C130
RY183%
TD220

Benchmarking is highly favored among large institutions due to their adherence to a prospectus, which mandates specific allocations across various sectors. They are required to maintain a predetermined amount of investment in each sector, preventing them from concentrating excessively in a particular sector, such as allocating 50% of their funds. As a result, these institutions consistently sell stocks that have performed well or have become overvalued, while actively seeking undervalued opportunities. This cycle of selling and identifying new investment prospects continues indefinitely, as they base their investment decisions on fundamental analysis.

Understanding this concept is crucial because it helps in identifying investment opportunities. For instance, if you observe a sector where one company is significantly undervalued and has a high level of institutional ownership, it may indicate that this company is likely to be the next buy. Conversely, if a company within the same sector suddenly becomes overvalued, it could serve as a signal for a potential short position. This is because the institutions are likely to begin liquidating their holdings in the overvalued company.

Benchmarking is not applicable or effective for all sectors. For instance, the biotech sector is not conducive to benchmarking due to the potential for a single company to release a new drug, causing its stock price to surge. In such cases, assessing profitability alone is insufficient; it is essential to consider future expectations for these new drugs and companies. Similarly, the tech sector poses challenges for benchmarking as tech companies can introduce new technologies at any time, making it riskier to rely solely on traditional benchmarking methods. Conversely, benchmarking is more straightforward for sectors such as banking or utilities, where the evaluation process is comparatively easier.