A benchmark is like a favorite food. It sets the standard and serves as a comparison when you try new things. Benchmarks in the stock market are often indexes and ratios. We can then use these benchmarks to help us make investment decisions through benchmark analysis.
Benchmark analysis is a dramatic way of describing comparing two or more metrics to evaluate performance. The idea of it is that we have a benchmark or market leader in an industry and compare it to another similar company. For example, Apple is a leader in the consumer electronics industry. Apple would prove to be a good benchmark if we are trying to make an investment decision on Lenovo.
There are many types of benchmarks you can evaluate, like competitive advantage, management experience, or even political risk. In this Bite, we will just be covering how to use indexes and ratios as a benchmark.
We covered stock indexes in a past Bite. They are simply a basket of several stocks that serve as a benchmark. The most commonly used benchmark index is the S&P 500. Historically, it has been able to return on average 10-11% a year. Using the S&P 500 can be a great way of comparing your own portfolio returns to what most investors consider the standard. If you have been fortunate enough to earn a return of 15% last year, then you should be happy. You beat the benchmark! If not, then it might be worth diving into some of the stocks you are holding.
We learned in the last Bite how to find ratios. Now, we get to compare them to a benchmark. It is important at this stage that you have a good understanding of the ratios you are comparing. Understanding that a lower P/E ratio is often more desirable than a high P/E ratio will help make more informed decisions to determine the superior stock.
That’s it! Benchmark analysis is quite simple and is most effective when done with ratio analysis. It’s like killing two birds with one stone. You already have the ratios so now you get to find out if it is a rockstar in its industry.
Now, let’s switch gears from fundamental analysis and begin exploring an alternative method, technical analysis.