US SEC regulations, Canadian CSA regulations, and UK FSA regulations require the inclusion of a peer group comparison in the applicable documents to be filed with those regulatory bodies. These regulatory bodies require transparency regarding peer groups selection used to assess competitive practices for the fulfillment of disclosure requirements. Peer group selection is an important factor in compensation and company performance evaluation. Utilizing a variety of methods to select peers ensures that competitive benchmarking provides a holistic view to shareholders, analysts and regulators of the market factors that influence company decisions such as those regarding executive compensation. Once a peer group has been selected, maintaining the consistency of that group over several years enables a company to better analyze market practices and identify emerging trends.
Determining the influences on peer group composition:
One of three purposes greatly influences the composition of a peer group depending on the requirements of the pertinent regulations:
- Pay level
- Pay best practices
- Performance comparisons
Screening for peers:
Selecting peers which share common profiles will provide reasonable benchmarks to support fact-based decisions. The evaluation process is comprised of several steps which allow the identification of the most appropriate comparison group:
- Identifying market competitors
- Identifying customer markets
- Indentifying labor markets
- Identifying capital markets
Once common competitors for markets, clients, labor and capital are identified, the peers should be screened for similar business complexity.
- Determining whether to use performance as a screen:
- Performance can change quickly and thus can lead to significant volatility in the peer group from year to year.
- Determining whether to include market capitalization as a screen
- Market capitalization is sometimes as a criterion for identifying comparably sized peers rather than revenue or assets. Revenue and assets are better for determining size comparability as they are not as volatile.
Peer Group selection issues and solutions:
Companies such as diversified holding companies or businesses undergoing major strategic changes may need a more comprehensive approach to peer group selection, as often there will be no peer equivalents from which to select an appropriate peer group. For these the following solutions have proven useful:
- Selecting companies with similar structures or business models:
- Including non-competitor companies in different industries, but with similar operating characteristics and business models can prove of value as these often manage comparable activities.
- Selecting upstream/downstream companies:
- If the business in which a company operates is so specialized that comparable peers cannot be found a company may consider selecting upstream or downstream peers from within its industry. These will deal with similar value drivers, risks and operations.
- Selecting global peers:
- Global peer groups are appropriate when a company which functions within a highly specialized industry, or functions largely cross-border and cannot find enough country-specific or similarly cross-border companies to include in a peer group. In these cases, a blended peer group which spans multiple geographies is a more accurate reflection of a company’s profile.
- Other options:
- In cases where a company competes in a limited market or when it has few direct or indirect peers of similar size, the capital markets may provide an alternative option for the selection of appropriate peers. These would be companies that capital market investors could include in the same portfolio. Some of the largest blue chip companies fit this profile; they manage very large amounts of capital. Diversified holding companies could also find appropriate peers in a similar manner. Here quantitative analysis is used to identify peer companies with share price movement that is statistically correlated with their own share price performance.