How to Choose Comparable Companies
Choosing a set of comparable companies – a comparable universe – is the first and most important step to comparable company analysis. The rest of your analysis and valuation is based on the set of comparable companies you identify at the beginning of your analysis. Therefore, it is important to make sure that you choose the right comparable universe, otherwise, you risk invalidating your valuation and all the work you put into developing your model.
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There are multiple factors that decide whether a company is a good comparable company for your model. Generally, when financial analysts select comparable companies, they are looking for firms that are most similar to the company they are trying to value.
The intuition behind this is that if investors are willing to pay a certain amount for a similar company, they should be willing the pay that same amount for the company that we are trying to value.
There are many factors that contribute towards whether a company is fit for your comparable universe. Here is a list of some of these factors:
- Industry Classification
- Growth Rate
- Capital Structure
Industry classification is an important factor when choosing comparable companies. Starting with a company’s industry will help an analyst find similar companies, as companies in an industry often operate similarly. There are many resources such as Bloomberg’s Industry Classification System that a financial analyst can use to identify a firm’s industry.
Another way to look at this is to consider what products or services are offered by the company you are valuing. Compare these to the products and services of the companies you are looking to include in your comparable universe.
For example, if you were looking for comparable companies for an automotive company that produces mid-sized sedans, Toyota and Honda would both be companies in the same industry. In contrast, even though it is also an automotive company, Aston Martin would not be a good choice as the company produces luxury sports vehicles.
Size is another factor to consider when looking at firms for your comparable universe. A comparable universe should ideally consist of companies that have similar size profiles to the company you are trying to value. This could be a comparison based on revenue, assets, number of employees, or other factors.
Though an extreme example, we can look at Activision Blizzard Inc. to explain why size is important. Activision Blizzard had a market capitalization of US$63 billion as of October 2018, an annual revenue of US$7 billion in 2017, and employs over 10,000 people. The company operates on a large, global scale. Thus, It would not be appropriate to use Activision Blizzard as a comparable company for an independent video game studio that has a team of 30 employees, since the two companies operate on completely different scales.
A key to finding comparable companies is similarity in operations. In this sense, geography is also a consideration to look at when selecting your comparable universe. Different regions have different consumer demographics, consumption culture, legal restrictions, and demand for products. A firm that exists in North America may not necessarily be successful in Asia if it does not change its product or the way it operates. Therefore, geographic region has an effect on the comparability of a firm.
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Investors pay attention to growth projections and growth rates to determine the value of a company. If two companies were completely identical except for growth rate, the company with a higher growth rate would naturally be valued higher. To visualize this, we can take a look at the formula for calculating a company’s terminal value. In its simplest form, the formula is as follows:
- FCF = perpetual free cash flows
- r = discount rate (usually the weighted average cost of capital of the firm)
- g = terminal growth rate
We can hold the following values constant and only change the growth rate to observe the effects of higher growth rates on the value of a firm.
- FCF = $10,000
- r = 10%
- g = 8% or 5%
A growth rate of 8% produces a terminal value of $500,000.
A growth rate of 5% produces a terminal value of $200,000.
It is clear with this calculation that the growth rate of a company widely influences the value that investors see in it. Therefore, it is imperative for an analyst to find comparable companies with similar growth profiles for their comparable universe.
It goes without saying that a firm’s profitability affects its value to investors. Like with growth rate, we can look at two firms, Firm A and Firm B, that have similar operations and capital structure. If both firms earn similar revenue but Firm A has higher margins, Firm A will be valued higher.
Higher margins are an indicator of financial performance. With greater margins comes greater profit and more opportunities to invest in growth or issue dividends to investors.
If an analyst selects firms that have widely different margins for their comparable universe, they risk throwing off their valuation as they are no longer using firms that have the same expectations of value. Therefore, profitability is an important metric for an analyst to pay attention to when selecting comparable companies.
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Finally, capital structure is another key consideration when choosing comparable companies for a comparable universe. The more debt a company has, the greater the risk shareholders adopt. This is because shareholders’ claims are second to debtholders’ in the case of bankruptcy.
If a company declares bankruptcy, its assets go towards paying back debtholders first. Only after debtholders’ claims are settled do equity holders have a chance at recovering their investments. This poses a risk to investors because a company may not have enough assets to settle all of the equity holders’ claims.
Investors demand a higher return because of the risk they face when a company is financed with more debt. As a result, a company with higher leverage typically trades at a discount.
A financial analyst should pay attention to the capital structure of the firms they are evaluating when selecting comparable companies. This way, the comparables valuation will not be inaccurate due to leverage differences between the comparable companies and the company the analyst is trying to value.
Constructing a Comparable Universe
In an ideal scenario, it would be best to find firms that fit all of these conditions. However, there are not always enough companies for a financial analyst to filter through if they use every single criterion we have listed. Sometimes an analyst will have to use fewer criterion, other times they may use more. It is important for an analyst to consider what factors are most important when valuing the company they are analyzing.
For example, if you are looking at a firm that has similar growth rates, margins, capital structure, size, and geography, but it does not fall in the same industry as the firm you are trying to value, it can still be used as a comparable company.
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