Have you ever come across a company whose shares are classified as being in one sector, but in reality, should sit in a different one? It matters from a valuation perspective.

For years, catering group Compass (CPG) was in the travel and leisure sector, sitting alongside travel agents, airlines and gambling groups. This seemed bizarre as running a canteen in a hospital or school is more of a service operation, yet investors often compared its fortunes to planes and pub operators which sat in the travel and leisure sector.

As part of their analysis, investors would compare Compass’ price to earnings ratio with its sector even though it stuck out like a sore thumb and was not an apples for apples comparison. Compass has subsequently been reclassified to the more appropriate consumer services sector where it sits alone in the FTSE 350 index.

Liberum analysts believe Greggs (GRG) should be the next company to move sectors. They argue it should be classified as a quick service restaurant rather than a food retailer, in reflection of how the business has changed over the years.

Analysts will often suggest a different sector classification as a means by which to justify a higher valuation. A cynic might say that some research notes are overly bullish because the author wants to make the company look good and win its business as corporate broker. If the current rating looks rich compared to peers, make a good argument for why it should move to a sector where higher valuations are the norm.

In Liberum’s case, I see a valid reason why it is saying Greggs should be reclassified. Just think about the definition of a retailer – it’s a business that sells products off a shelf in a shop or online via a website.

Greggs started out by selling loaves of bread from its bakery counter. Today, it serves fast food cuisine with the option of eat-in or takeaway. That helps differentiate Greggs from a convenience store or supermarket where you might buy a loaf of bread and a pint of milk as ingredients for preparing meals or drinks at home.

Admittedly, Greggs looks expensive compared to most other retailers, trading on 21.4 times forward earnings versus a 14-times average. Quick service restaurants command a higher valuation, with a median 17.5-times for the European constituents and 26.8-times for those listed in the US. The median valuation for owners of Domino’s Pizza master franchises is 24.2 times 2023 forecast earnings.

Within this peer group, Greggs’ 2023 price to earnings ratio is on a par with Wendy’s (WEN:NASDAQ) and Restaurant Brands International (QSR:NYSE) which owns Burger King, Tim Hortons, Popeyes and Firehouse Subs. These rival companies have considerably greater scale in terms of restaurant numbers and brands that are known in multiple countries. However, Greggs offers the prospect of positive earnings growth in 2022, whereas the other two companies are forecast to see a decline. That’s certainly a reason for investors to take a deeper look.

Starting the debate about how Greggs stacks up against quick service restaurant peers is an important one, and long overdue. It could be the catalyst to get a lot of investors to give Greggs another look and see it in a new light.

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