Classify a stock by sector, cyclicality and business model so you compare it with the right companies.
Before you judge whether a multiple is high or low, decide what kind of company you are looking at. Give every company in your comps table three labels: sector, cyclicality and business model.
Larkspur shows how much this matters. Two data providers classify it differently. One puts it in semiconductors, beside chip designers that trade at 30 times earnings (an invented figure, like every Larkspur and peer number below). The other puts it in industrial machinery, beside makers of pumps and conveyor belts that trade at around 13 times. Larkspur trades at 11 times earnings. Against the chip designers, Larkspur looks very cheap. Against the machinery makers, it looks ordinary. The company and the price are the same in both cases, and the opposite conclusions come only from the classification box.
The sector label describes what the company sells. The most widely used system is the Global Industry Classification Standard (GICS). MSCI and S&P launched it in 1999 and still maintain it together. GICS has four levels, from broad to narrow: sectors, industry groups, industries and sub-industries. It sorts companies mainly by where their revenue comes from. Index providers and many data sites use GICS, and others use similar systems of their own.
Sector codes are a useful starting point. Analysts assign them by reading the same reports you read, though, and borderline companies get borderline classifications. A supplier of parts to chip equipment makers can reasonably sit in a semiconductor equipment category within information technology, or in an industrial machinery category within industrials. Neither is wrong, and Larkspur sits on exactly this border.
A sector code also tells you little about how a company makes money or how steady that money is. The other two labels cover those questions.
The cyclicality label describes how profit behaves when the economy turns. Companies fall into three groups.
Cyclical companies have profit that rises and falls with the economy or with an industry cycle. Chip suppliers, shipping lines, commodity producers, carmakers and builders are typical. Larkspur's FY4 results show the pattern: revenue fell 15% and operating profit fell about 41%. Operating profit falling much more than revenue is the mark of a cyclical company.
Defensive companies sell things people keep buying in a recession, such as groceries, electricity and basic healthcare. Their profit moves much less.
Secular-growth companies ride a long trend, such as a shift in how people pay, shop or work. That trend lifts revenue through most cycles, though rarely through all of them.
Each group calls for a different multiple approach. For a defensive company, current profit is a fair guide to future profit, so a steady P/E works. For a cyclical company, current profit may be at a peak or a trough, so you judge it on normalised earnings, as Lesson 9.2 showed. A secular-growth company earns a higher multiple only if its growth lasts long enough to justify it. Lesson 8.5, Reverse DCF: what the market is already pricing in, gives you the test for that.
The business model label describes how the company earns its money. Two features matter most for multiples.
The first is capital intensity, meaning how much investment each extra dollar of sales demands. Capital-light businesses, such as software companies and brands that outsource manufacturing, need little new investment to grow, so more of their profit becomes free cash flow. Capital-heavy businesses have to keep buying equipment before they can sell more. Larkspur, with its machine shops, is capital-heavy. In Lesson 7.6, Forecast from drivers, with mean reversion and reinvestment, its capital spending went into the model at about 8% of revenue.
The second is how revenue repeats. Recurring revenue from subscriptions or long fixed-fee contracts is more predictable than repeat orders that vary with volume. Lesson 7.2, Income statement: revenue quality, margin stack and one-offs, established that Larkspur's customers rarely leave, but the amount they order moves with the chip cycle.
Across markets, capital-light businesses with recurring revenue usually trade at higher multiples than capital-heavy businesses with cyclical revenue, because each dollar of their profit is more certain and more available to shareholders. That gap is a fair reason for a valuation difference, and you shouldn't treat it as a mispricing.
Marcus picked Larkspur's five peers in Lesson 9.3, Choose a peer group that is really comparable. He now gives each company the three labels.
Larkspur, Peer A, Peer B and Peer C: semiconductor equipment supply chain; cyclical; capital-heavy contract manufacturing with repeat orders. Peer D: industrial machinery parts; cyclical with slower growth; capital-heavy. Peer E: semiconductor equipment supply chain; cyclical; designs and builds whole subsystems, with more engineering content and a recurring service business.
The labels explain part of the valuation gap Marcus found in Lesson 9.3. Peer E's P/E of 24 is more than an American premium. Peer E sells designed subsystems with a recurring service stream, and more of what it sells is its own content than a parts machinist's would be, and investors pay for that. Peer D's slower growth and lower margin explain part of its low multiple.
Larkspur and Peers A, B and C share all three labels, so they form the core of the comparison. If Marcus had to drop one peer, he would drop Peer E.
This also settles the data providers' disagreement. Against chip designers, Larkspur looks cheap only because it is being measured against a different business model. Against industrial machinery, it looks ordinary because that box ignores its cycle. Against peers with the same three labels, Larkspur trades a little below their median. The reasons for that discount, customer concentration and size, were identified earlier in the course.
First, assign the sector, starting from GICS or a similar system and checking borderline cases. Next, assign the cyclicality (cyclical, defensive or secular-growth) from how profit behaves in a downturn. Then assign the business model: capital-light or capital-heavy, and recurring or volume-driven repeat revenue. Choose the multiple approach to match: a steady P/E for defensive companies, normalised earnings for cyclical ones and a reverse DCF test for secular-growth ones. Compare only against peers that share the same labels. Treat gaps to peers that differ as explained differences rather than mispricings, and drop the least comparable peer if you need to. Finally, check for the three common misclassifications.
The first misclassification is calling a cyclical company defensive because it has been steady for a few good years. The second is calling a capital-heavy company "tech" because it sells to technology firms. The third is comparing a REIT or a bank with ordinary companies on P/E. As Lesson 8.7, Valuing banks and REITs, where a standard DCF breaks, showed, banks and REITs need their own yardsticks.
For the activity, put your own company and its five peers into one table with these three labels for each.
Make one table that classifies the company you modelled and its five peers by sector, cyclicality and business model.
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