How Should CFOs Select Peer Firms for Benchmarking?

Knowing how to select a good set of comparable firms can improve CFOs’ internal performance assessments and aid with decision-making.
Rani Hoitash, Ahmet Kurt, Udi Hoitash, and Rodrigo VerdiMay 2, 2023
How Should CFOs Select Peer Firms for Benchmarking?
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CFOs can improve their decision-making and forecasts by benchmarking their companies against peers. However, finding the “right” peers for benchmarking is not an easy task. A key question for finance chiefs is whether your company and selected peers present the same type of information on the financial statements (e.g., translation adjustment, last in/first out reserves, restructuring costs, and derivative gains/losses). If not, your selected peers may not be appropriate, making benchmarking exercises less meaningful.  

Like internal decision-makers, various outside stakeholders, including investors, analysts, bankers, auditors, and corporate boards, engage in peer benchmarking using information reported on companies’ financial statements. Analysts, for instance, often use comparable peer firms for performance and valuation benchmarking. 

Finding a Good Fit for Benchmarking

The commonly used methods of defining and selecting peers typically focus on the industry or index membership and the similarity in firm size or valuation multiples. While the existing methods are intuitive, they do not inform decision-makers regarding the extent to which the focal firm and its chosen peers are benchmarkable from a financial statement standpoint. 

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Rani Hoitash

To aid financial statement users with their benchmarking decisions, we have developed a measure of financial statement benchmarking, which is based on a forthcoming article in The Accounting Review

Our measure of financial statement benchmarking (FSB) captures the degree of overlap in financial statement items reported by two firms and indicates to what extent two firms are a “good fit” for benchmarking. 

Our method of constructing FSB is akin to putting two sets of financial statements side-by-side and marking the same items that appear in the two sets. The higher the number of overlapping items reported by the focal firm and its peer, the greater the FSB score and thus the greater the comparability of the two firms. 

Ahmet Kurt

We constructed FSB using two data sets: (1) standardized data from the S&P’s Capital IQ Compustat database and (2) as reported eXtensible Business Reporting Language (XBRL) data from the SEC’s EDGAR. FSB ranges between 0 and 1, with 0 indicating no overlap in financial statement items reported by two firms and 1 indicating a complete overlap. The average FSB across all pairs in our sample is 0.59. 

Consider Walmart as an example. Morningstar lists Amazon and Costco Wholesale as the two key peer firms of the company. In contrast, Amazon does not appear among peer firms suggested by Yahoo! Finance, which lists Home Depot as a key peer firm. In line with this observation, our measure suggests that from a financial statement comparison perspective, Home Depot would be a more suitable benchmark for Walmart than Amazon. 

Specifically, our calculations show that in 2021, Home Depot and Walmart had an FSB score of 0.83 (i.e., the number of overlapping financial statement items is 83% of all unique items reported by the two firms). In contrast, this figure is 0.71 for Amazon and Walmart. 

Positive Benchmarking Outcomes

The logic behind FSB and its benchmarking implications is straightforward. If a peer firm reports fewer of the same financial statement items reported by the focal firm, there is less relevant benchmarking information for decision makers (e.g., there is no available benchmarking data point for research and development expenditures if the item is missing for the peer firm). Thus, a lower FSB score implies that making a meaningful comparison between the two firms would be more difficult and costly. 

Udi Hoitash

We validate FSB using over 8,000 peer firms selected by analysts for performance benchmarking in their reports and over 100,000 peer firms selected by corporate boards for compensation benchmarking. Lending credibility to our measure, we find that analysts and boards are more likely to choose peer firms with financial statements that are more benchmarkable to those of the focal firm as measured by FSB. 

Do analysts benefit from using more benchmarkable peer firms when building their forecasts for the focal firm? The results show that when the set of chosen peer firms has a high FSB score, analysts’ earnings forecast accuracy increases by 23.3%. 

Similarly, choosing compensation peers with high FSB is associated with positive benchmarking outcomes. In economic terms, the overpayment of the CEO is lower by 6.1% when the set of compensation peers has a high FSB. 

Rodrigo Verdi

Does having financial statements that are easier to benchmark against industry peers offer benefits in debt markets? When a company’s financial statement items exhibit greater overlap with those of other firms operating in the same industry, analysts make more accurate debt forecasts, and credit rating agencies issue ratings with lower type I error rates (i.e., missed defaults). And these effects are due to balance sheet rather than income statement benchmarking.

Ways to Improve Financial Statement Benchmarking

As our evidence shows, having a high versus low FSB has significant positive economic implications for both firms and capital market participants. It reduces information processing costs and improves decision-making accuracy. Hence, CFOs are advised to pay close attention to their companies’ FSB in relation to the industry and other peers.  

What are some ways to improve financial statement benchmarking? Financial statements are a joint product of a firm’s underlying economics and financial reporting. While little can be done with respect to underlying economics, some improvement can be achieved regarding financial reporting. 

For instance, CFOs can improve accounting comparability by avoiding industry-atypical accounting choices. As accounting comparability increases, so does the ease of benchmarking the financial statements of peer firms. 

Having a high versus low FSB has significant positive economic implications for both firms and capital market participants.

Similarly, financial statement presentation also plays an important role in this process (e.g., reporting advertising expenditure as a separate line item instead of grouping it with other expenses). Relatedly, when filing financial statements with the SEC in XBRL, finance chiefs can guide their financial statement preparation group to minimize the use of firm-specific, extended XBRL tags. Doing so helps facilitate benchmarking.  

For both internal and external users, financial statement benchmarking has the potential to offer valuable insights into the company’s operations and finances. However, the success of financial statement benchmarking applications depends on the availability of peer firm data. 

Selecting a good set of peer firms, which report more overlapping financial statement items as the focal firm, can facilitate CFOs’ and other executives’ internal performance assessments and aid with their decision-making. In contrast, using peer firms with low FSB may render benchmarking exercises not so helpful. 

Rani Hoitash and Ahmet Kurt are from Bentley University, Udi Hoitash from Northeastern University, and Rodrigo Verdi from MIT.