A couple of weeks ago, I posted the first video in an educational series built around a three step investing plan: [buy good companies, don't overpay, then do nothing](https://www.reddit.com/r/ValueInvesting/s/hdcJJToliA).
But how do you determine what a good company is?
One way to look at this is to compare business fundamentals (growth, margins, returns on capital, cash conversion, liquidity, debt, etc) against certain thresholds, the same bar for every company. Say the rule is 'gross margin above 40% is strong' - you filter for companies meeting that criterion, as discussed in this post: [what actually makes a company 'good'](https://www.reddit.com/r/ValueInvesting/s/EI0oRUprEB). That's how most of the screeners work.
However, the problem with this approach is that you judge a grocer and a software company on the same scale. A grocer will never meet the strong criteria set for software companies, even if it's a high-quality company. So another approach is to get rid of the absolute thresholds and compare the company with its peers in the same sector or industry. That peer comparison approach gives you a second way to determine business quality.
Say you have 50 companies in a sector and you are interested in gross margins. Rank the companies by their gross margins from 1 to 50 without worrying about any thresholds and simply look up the position of the company in this list. Say your company has better gross margins than 40 of the companies, so its percentile rank of your company is 80%, which means your company has strong margins within its sector (the percentile is just what share of the peer group it beats). If its gross margin is only better than 5 companies, that means the percentile is 10%, i.e the company's gross margin is poor in the sector. Do this for all metrics you are interested in, and you'll get a better idea of the company's quality relative to the sector.
This new video discusses this second relative approach to analysing business quality, using PepsiCo as an example. It complements the threshold-based approach commonly used to evaluate business quality and offers some benefits compared to that approach as it enables you to take teh context into account while evaluating businesses.
[https://youtu.be/V8jWo15nCaM](https://youtu.be/V8jWo15nCaM)
Educational only, not investment advice, and the example company is an illustration, not a recommendation.
