You will be able to classify a stock by sector, cyclicality and business model so you compare it on the right basis.
Two data providers put Larkspur in two different places. One files it under semiconductors, next to chip designers trading at 30 times earnings, which makes Larkspur at 11 look like a steal. The other files it under industrial machinery, next to makers of pumps and conveyor belts at around 13 times, which makes it look ordinary. Same company, same price, opposite conclusions, and the only thing that changed was the box it was put in.
Before you judge whether a multiple is high or low, decide what kind of company you're looking at. This reading gives you three labels to attach to every company in your comps table: its sector, its cyclicality and its business model, with made-up figures where numbers appear.
The most widely used sector system is the Global Industry Classification Standard, or GICS, which MSCI and S&P launched in 1999 and still maintain together. It sorts companies into four levels, from broad sectors down through industry groups and industries to narrow sub-industries, mainly according to where their revenue comes from. Index providers and many data sites use it, and others use similar systems of their own.
Sector codes are a useful starting point, but they're assigned by analysts reading the same reports you read, and borderline companies get borderline answers. A supplier of parts to chip equipment makers can reasonably land in a semiconductor equipment category within information technology, or in an industrial machinery category within industrials, and neither choice is wrong. A sector code tells you what a company sells. It says much less about how the company makes money or how steady that money is, which is why you need the next two labels as well.
Sort companies into three groups by what happens to their profit when the economy turns.
Cyclical companies see profit rise and fall with the economy or an industry cycle: chip suppliers, shipping lines, commodity producers, carmakers, builders. Larkspur's revenue fell 15% in FY4 and its operating profit fell about 41%, which is the signature. Defensive companies sell things people keep buying in a recession, such as groceries, electricity and basic healthcare, so their profit moves much less. Secular-growth companies sit on a long trend, such as a shift in how people pay, shop or work, that carries their revenue up through most cycles, though rarely all of them.
Each group deserves a different multiple. A defensive company's current profit is a fair guide to its future profit, so a steady P/E applies to it. A cyclical company should be judged on normalised earnings, as lesson 9.2 showed, because its current profit may sit at a peak or a trough. A secular-growth company earns a higher multiple only if the growth lasts long enough to justify it, which is exactly what a reverse DCF tests, as in lesson 8.5, Reverse DCF: what the market is already pricing in.
The third label asks 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. A capital-light business, such as a software company or a brand that outsources its manufacturing, needs little new investment to grow, so more of its profit becomes free cash flow. A capital-heavy business, such as Larkspur with its machine shops, has to keep buying equipment before it can sell more, which lesson 7.6, Forecast from drivers, with mean reversion and reinvestment, built into the model as capital spending of about 8% of revenue.
The second is how revenue repeats. Recurring revenue from subscriptions or long contracts with fixed fees is more predictable than repeat orders that vary with volume. Larkspur's revenue repeats in the sense that customers rarely leave, as lesson 7.2, Income statement: revenue quality, margin stack and one-offs, put it, but the amount moves with the chip cycle.
Put the two together and a pattern holds 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 both more certain and more available to shareholders. That's a fair reason for a gap, not a mispricing.
Here is Marcus's classification of Larkspur and its five peers from lesson 9.3, Choose a peer group that is really comparable.
Larkspur and Peers A, B and 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 service business that recurs
The table explains some of the gap from lesson 9.3. Peer E's P/E of 24 isn't only an American premium. It sells designed subsystems with a recurring service stream, a business with more of its own content than a parts machinist, and investors pay for that. Peer D's slower growth and lower margin explain part of its low multiple. Larkspur, Peers A, B and C share all three labels, which makes them the core of the comparison. If Marcus had to drop one peer, it would be E.
Now the opening puzzle has an answer. Against chip designers, Larkspur looks cheap only because it's 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, it trades a little below their median, and the reasons are the customer concentration and size you've already found.
Three misclassifications catch investors more than any others. Calling a cyclical company defensive because it's been steady for a few good years. Calling a capital-heavy company "tech" because it sells to technology firms. And comparing a REIT or a bank with ordinary companies on P/E, when lesson 8.7, Valuing banks and REITs, where a standard DCF breaks, showed they need their own yardsticks.
For the activity, you'll put your own company and its five peers into one table with these three labels for each.
Classify your modelled company and its five peers by sector, cyclicality and business model in one table.
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