What is Comparable Company Analysis?
Comparable Company Analysis is a relative valuation method in which a company’s value is derived from comparisons to the current stock prices of similar companies in the market.
Once the peer group of comparable companies and the appropriate valuation multiples have been established, the median or mean multiple of the peer group is applied to the corresponding metric of the target company to arrive at its comps-derived valuation.
Comparable Company Analysis: Training Tutorial
The premise of comparable company analysis is that similar companies provide an informative point of reference that can be used to derive an estimated valuation of the target company.
The implied valuation from trading comps is not meant to be a precise measure, but rather to set parameters for the target company based on the current market pricing of comparable companies.
A common analogy used to explain the concept of comps is the example of estimating the fair market value (FMV) of a home. If you researched the estimated value of nearby houses using sites such as Zillow, you’ve essentially performed a simple comps analysis.
However, the process and type of considerations become substantially more intricate when it comes to valuing companies.
Valuation Multiple Analysis: Quick Review
A valuation multiple consists of a measure of value in the numerator, whereas the denominator is an operating metric.
- Numerator → Value Measure (e.g. Enterprise Value, Equity Value)
- Denominator → Value Driver (e.g. EBITDA, EBIT, Net Income, EPS)
An important rule is that the represented investor group – in other words, the capital provider(s) – must match on both the numerator and the denominator. Otherwise, the multiple cannot be used due to a mismatch in representation.
For example, enterprise value represents all the providers of capital (e.g. equity, debt) while equity value pertains only to common shareholders.
While the P/E ratio is widely recognized and used among retail investors and is also taught in academia, the most commonly used multiples in the industry are based on enterprise value, as such multiples are independent of the capital structure and focus on the core operations of the company.
Learn More → Valuation Multiple
Comparable Company Analysis Overview (Step-by-Step)
- Step 1. Compile Peer Group → The first step is to select the peer group, which will be composed of publicly traded comparable companies that are ideally competitors of the target or operate in a similar industry.
- Step 2. Industry Research → The next step is to collect applicable information from publicly available sources related to the specific target company, as well as the ongoing industry and market trends to understand the factors affecting how the market values companies in a certain industry.
- Step 3. Input Financial Data → Once an understanding of the industry is formed, the subsequent step is to collect the financial data of each comparable company, making sure to “scrub” (adjust) the financials for non-recurring items, accounting differences, leverage differences, and any cyclicality or seasonality. If the situation requires, you may also need to calendarize each company’s financials to standardize the dates (i.e. convert different ending fiscal year dates to a common timeframe).
- Step 4. Calculate Peer Group Multiples → With the financials input, the valuation multiples can be calculated and compared against one another in the output sheet. As a general convention, the multiples are typically displayed on a last twelve months (LTM) and the next twelve months (NTM) basis, with the minimum, 25th percentile, median, mean, 75th percentile, and the maximum of each metric also calculated and summarized.
- Step 5. Apply Multiple to Target → In the final step, the median or mean multiple is applied to the target’s corresponding metric to get the comps-derived value of the target. It is important to not neglect the fundamental drivers impacting the valuation – otherwise, it’ll be difficult to defend the rationale of why a target should be valued in the lower (or higher) end of the range.
Comparable Company Analysis: Pros and Cons
The accuracy of trading comps analysis is contingent on the selection of comparable companies.
As a general rule, the more stringent the screening process for comparable companies is, the more reliable the trading comps valuation is going to be.
If comparable companies are absent in the public markets, the screening process to put together a peer group becomes less strict, which directly causes the comps valuation to lose credibility.
But while the implied valuation output from a trading comps analysis could be seen as a more realistic assessment of market pricing (and are based upon actual prices in real-time), comps are vulnerable to how the market can be wrong – and the market often does indeed misprice securities, particularly for those with smaller followings and less trading volumes.
A common misconception is that comps do not require as many assumptions as a discounted cash flow analysis (DCF). In fact, the same operating assumptions are made, but they are made implicitly rather than being explicitly chosen assumptions.
The inherent assumption behind comparable company analysis is that the market consists of rational investors.
But material disconnects between the pricing of securities and company fundamentals can still occur, which increases the importance of not relying on a single valuation method.
Given these drawbacks, trading comps should be used in conjunction with the other valuation methodologies like the DCF – as opposed to being a standalone method (i.e. “sanity check”).
if you have all the financial inputs it takes less than 30 minutes, Usually easier for public companies , since the data is available. But you might need some time to scrub the financials
How many hours does it take to spread ONE trading multiple (EV/EBITDA), using filings, from scratch? I am asking this question since I need to do scoping of work at office. Awaiting your kind reply ..