Comparable Company Analysis is a tool to evaluate the value of business in relation to the metrics of businesses in the same industry. In comparable company valuation, the value of the asset is evaluated as per the values assessed by the market for similar assets. These similar assets are also popularly called comparable assets, hence, giving the valuation a term “Comparable Company Analysis”. It is also called relative valuation in financial world. The comparable company starts valuation of itself by identifying the similar companies in the same industry, focusing on the required valuation tools, identifying and calculating multiples and then preparing valuation statement.
Why Should We Use Relative Valuation?
The Discounted Cash Flows approach used in this solution has been widely popular but it is the relative valuation which can support assumptions when estimating the value of the company. A recent example is due to US President Trump’s comment on foreign pharmacy companies, the whole pharmaceutical sector took a down turn. Investors always analyze one stock with others comparing in prices to that of similar stocks. Extending this analogy to the assets, the comparable company establishes the standardized value to the valuation model in relation to its peer businesses of the industry. Relative valuation is done using the companies having similar cash flows, risk and potential growth. It is next to impossible to have completely identical business model. So, a standard is created among various multiples of the businesses.
One more reason is that despite discounted cash flows being popular as a valuation tool, adding comparable company analysis to the mix would make company appealing to larger audience of investors.
How to identify comparable companies?
The foundation to establish comparisons among the peers for valuation shall be based on the identical business line and model of business structure. It is very important to conduct preliminary study to identify the comparable companies. The identification procedure is categorized into following steps:
Identifying the industry:
It is very easy to categorize the industry the company is operating on. However, for specific business lines, it is uphill task. There is broad industry classification which cannot be relied on. If it is difficult to find the comparable company, one can make certain assumptions or shall not do relative valuation of company.
Understanding the Identical company:
Once comparable companies alongside industry is classified, one should start diving into the details of description of company. One can understand about company by visiting the company’s website and comparing own company products with others. The various research reports and financial details available in the public domains shall be carefully scrutinized.
Identifying Key Competitors:
It is the most critical step to identify key competitors. They are the exact rivals indulged in similar line of business with similar business structure. These have more or less similar asset and liabilities structure. Key competitors can be identified by analyzing in depth various research reports, public filings of the company, Yahoo Finance and other public domains.
Steps for Comparable Company Analysis
The company information in public domain plays a critical role in studying the identical companies. Then we have to understand the relation with regards to Market Capitalization and enterprise value. Less the variation, the better. Operational metrics such as revenue, growth, ROE, profit margins, etc. plays a critical role in comparable company analysis. After that valuation can be undertaken using multiples analysis. A range of Excel templates for business valuation can be used to assist with this type analysis.
Before we venture out into the valuation of company, we need to understand the definition of multiples. Multiples are predefined terms on which the parameters of standard numbers are based on. Multiples can be quantified by different users in different ways. But in comparative company analysis, we use it in relative mode. In short, multiples are standardized estimates of price.
Multiples can be based on cash flow or some performance metrics of similar business enterprise. The most common multiple used is P/E multiple. Other multiples are EV/EBITDA, EV/Sales, EV/EBIT. Here, EV means enterprise value. Comparable company analysis revolves around how the multiples are calculated, analyzed and factored into valuation. Now, let’s look at the steps for valuation:
Defining the multiples
It is the fundamental step and hence it is very critical to ensure that right multiples are identified and defined as per business model. The various categories of multiples that ought to be defined are as follows:
- Book Value Multiples
- Earnings Multiples
- Industry specific variables and
- Revenue Based Multiples.
Describing the multiple
Multiples must be carefully described using certain assumptions based on the company’s business model. Certain factors that are existing in identical company may not exist in company that is valued. Hence, these factors should more or less adjusted to make fair valuation. The multiple shall be described on the following basis:
- If earnings multiples are used, whether the accounting rules has been consistently applied?
- What are the variations (average and standard) across the industry?
- How shall fundamentals be adjusted across the industry?
Analyzing the multiples
Variables always exist in comparable companies. Hence it is necessary to calculate the variable effect as fair as possible. The nature of relationship between variables and multiples shall be carefully analyzed and taken into account. The multiples shall be analyzed on the following basis:
- Has the multiple changed over time?
- What are fundamental factors that impact the multiples?
- How has the change in fundamentals changed the multiple and relative beta among those?
Applying the multiple
After analysis, standardization is reached among various multiples. Standard means fair in financial world. All we need to do know is make valuation sheet, jot down the multiples and estimate the fair valuation of company. The differences always exist in assumptions and multiples taken. So, in practice, valuation is made giving specific range.
Multiples shall be used in the rational approach. The abuse of multiples can result in either overvaluation or undervaluation of comparable company which should be entirely avoided. Hence, renowned Finance Professor Aswath Damodaran states that the problem with multiples is not with the use but with the abuse. Therefore, assumptions about multiples shall be fairly made and accounted for.