Comparable Company Analysis
Is a financial modeling technique used by many individuals in finance to decide the market value of a company
A comparable company analysis is a financial modeling technique used by many individuals in finance to decide the market value of a company.
Valuing a company is extremely important to most front office roles, including investment banking, private equity, asset management, and sales & trading.
Typically you can expect the analysts or associates to be responsible for carrying out the analysis, and its execution must be meticulous and flawless because it will have major implications on the transaction that the team is working on.
Comps analysis is one of 3 main financial modeling techniques, with the other 2 valuation techniques being the discounted cash flow model and the precedent transactions analysis.
However, one aspect that makes the comparable company analysis stand out is that it takes on a relative valuation approach by comparing the target to similar companies within the industry.
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In contrast to a fundamental valuation approach, the comps analysis does not attempt to establish an intrinsic value of the target. Rather, the comps analysis focuses on similar companies (hence the name comparable).
The logic is not difficult to grasp - customers wouldn’t buy food from Burger King if the prices of its burgers are unreasonably higher than Mcdonald’s burgers because both fine establishments pretty much serve the same type of food.
Why would customers willingly buy overpriced food?
This line of reasoning is also applied to the comps analysis. Clearly, many companies sell similar products, target the same customer demographics, and possess identical assets.
From an investor’s perspective, these companies should be trading around the same multiples because their operations are fundamentally the same. This is exactly what justifies the comps analysis.
So what is the typical comparable company analysis process? Here are the steps:
- Identify businesses that are similar to the target.
- Extract specific financial information from the comparable businesses’ financial statements (e.g., EBITDA, market capitalization, net debt, etc.)
- Compute the comparable companies’ valuation multiples such as P/E ratio or EV/EBITDA ratio
- Calculate the average valuation multiple of the comparable companies, such as the average P/E
- Multiply the target’s financial information (net income, EBITDA, etc.) with the calculated average valuation multiple to determine the value of the target, which would typically be market capitalization or enterprise value.
This may seem fairly straightforward, but there are many factors to consider when performing the comps analysis in practice. First, when valuing a target, the selected comparables must be as similar to the target as possible.
Some general classifications would include industry, geographical location, or size. Still, you would be surprised at how difficult it would be to identify comparables when the target operates in a niche sector.
Nevertheless, many software that investment banks use (Bloomberg Terminal, Factset, Capital IQ) will have a function that generates a list of comparable companies. So that would be an excellent place to start filtering your list.
Valuation multiples are used because comparable companies should trade around the same values proportionate to their earnings (or some other factor such as revenue).
It would be irrational to assume that Apple and Samsung should be worth the same value when they both have very different net incomes or EBITDA.
Furthermore, it wouldn’t be wise to rely on only one comparable to value the target because that would be too much dependency on the comparable. That’s specifically why an average of numerous comparables are used instead.
Example of the comps analysis
As usual, it is always easier to understand when given an example. Therefore let’s try and run a simplified example of this analysis.
Let’s say you work at a fictitious soft drink company, Apes Beverages, and your company sells a soft drink called Gorilla Gulp that is sold all across the United States.
The drink has been a significant success since it was introduced 10 years ago, and Apes Beverages is looking to expand to the next level.
They need capital to open another factory to increase supply while simultaneously increasing margins and lowering variable costs through exploiting economies of scale.
The CFO has decided that Apes Beverages is ready to go public via IPO and needs your help in deciding the company’s value. He tells you to run a comps analysis and get back to him, or you’re fired by the end of the day.
You personally drink 5 cans of Gorilla Gulp a day, and you want this IPO to be a success. You’re also not afraid because you’ve mastered the comps analysis after going through Wall Street Oasis’s financial modeling Elite Modeling Package. The analysis will look something like this:
|Financial Metrics||Valuation Metrics||Multiples|
|EV/ EBITDA 2020
|The Coca-Cola Company||10,870||12,150||4,330||61.53||266,425||44,240||310,665||28.58||25.57|
|Monster Beverage Corp||1,690||1,860||529.36||79.16||41,904||22.38||41,927||24.81||22.54|
|Keurig Dr Pepper Corp||3,280||3,580||1,420||37.68||53,506||13,411||66,917||20.40||18.69|
Discussions of comparable company analysis
The comps analysis is an extremely helpful valuation technique because it uses readily available public information.
The logic behind the comparable company analysis is also very sound. A key benefit is that it infuses reality into the analysis because it uses actual figures driven by underlying market sentiments.
The model isn’t overly theoretical, and the only assumption which is also very acceptable is that companies that are similar in nature should be trading at similar multiples.
However, there are some caveats to the comps analysis. Because the model relies on the value of other companies to drive the analysis, there is some dependency on the market. Therefore, if markets are not efficient, the target won’t be fairly valued.
In fact, the comps analysis would be wildly inaccurate if the data used were during periods of boom or recessions because many would argue that prices are unreflective of fair value during those periods.
Another note is volatility. Every day, share prices are changing, which results in a fluctuating market capitalization which leads to a non-fixed valuation multiple, making it difficult to decide which exact point in time most accurately reflects the true P/E of a comparable.
A common scenario is when analysts have prepared a comparable company analysis for a presentation. However, the meeting gets postponed to the following week, and the analysts would be forced to update the comps table for the following week.
Lastly, one drawback of using the valuation multiples such as those in the example above is that the figures are historical. Many individuals consider markets forward-looking, where prices don’t trade at existing earnings but rather what the market deems future earnings to be.
Therefore, many analysts sometimes prefer using forward multiples such as forward P/E ratios that utilize estimated future earnings or even blended forward P/E, which incorporates historical and future estimated earnings.
Comparable company analysis vs. discounted cash flow model
The discounted cash flow model (DCF) uses a fundamental approach where the target’s future free cash flow is estimated and subsequently discounted back into the present value to determine the target’s intrinsic value.
Therefore this makes the DCF follow an entirely different methodology from the relative valuation approach that the comps analysis uses.
For the comps analysis, it's an apples-to-apples comparison. Fundamentally similar companies should be sold for the same price.
It is worth noting that the comps analysis does NOT attempt to determine what that fundamental value is, but rather it takes the market price of comparables and applies it to the target.
It is possible that the market price does not reflect the true value of the firms, but what it does reflect is the price that investors are willing to pay. From a practical standpoint, some might consider that much more important.
Which is the more preferred valuation method? It's impossible to say because both have their pros and cons. However, many people will criticize the discounted cash flow model for being overly theoretical, relying on many assumptions that sometimes might not be realistic.
In practice, no analyst has ever been able to accurately forecast a company's market capitalization using a discounted cash flow model.
The comps analysis does have its limitations as well. Finding similar companies to the target is not as simple as it may sound. Businesses are complex institutions with different organizational structures, revenue streams, standard operating procedures, etc.
When industries become very niche, it won't be easy to find comparables to the target.
In reality, analysts are likely to be carrying out both the discounted cash flow model and the comparable company analysis because financial modeling can only go so far.
These valuation techniques are better suited to serve as a benchmark and guideline to a company's estimated value rather than its quintessential value.
Comparable company analysis vs. precedent transactions analysis
Many people consider the precedent transaction analysis a subset of the comparable company analysis. In fact, the precedent transaction analysis also uses a relative valuation approach.
What the precedent transaction analysis does is that it seeks out the information of specific historical transactions and uses its details to base the price of the target (hence the name precedent).
The main similarities between the comps analysis and the precedent transaction analysis are that they rely on the valuation multiples of other companies to price the targets. They show actual prices that investors paid for comparables.
However, it would be wildly inaccurate to call them identical. Here are some key differences between the comparable company analysis and precedent transaction:
- The first one utilizes current market prices, while the second analysis looks for historical deals. Therefore, the precedent transaction will have greater difficulty finding comparables.
- The comparable company analysis values companies using current market conditions, which could be biased depending on the economic cycle.
However, the timing of historical deals could be far from when the precedent transaction analysis is being carried out. Therefore, the precedent transaction analysis can sometimes refer to deals that are considered outdated.
- The comparable company analysis often results in lower valuations compared to the precedent transaction analysis because there are control premiums that push the valuation higher.
Because the precedent transaction analysis evaluates actual historical deals, the control premiums existed to entice the current owners to sell their company. If this is not subtracted, then any valuation under the precedent transaction can sometimes be considered overvalued.
Which is the more preferred valuation method? As with the above, it is hard to say. However, what is worth mentioning is that many people consider the precedent transaction analysis to be more relevant to those working on M&A deals and are looking to merge with or acquire targets.
On the other hand, comps analysis is more widely used across various transactions such as IPOs, private placements, etc.
P/E VS EV/EBITDA
When running the comps analysis, analysts can use a variety of valuation multiples, including EV/sales, EV/EBIT, etc.
However, the most common multiples used will be the P/E and EV/EBITDA ratios. Therefore it is vital to know the differences between P/E and EV/EBITDA.
The P/E ratio stands for the price to earnings. Essentially it demonstrates how many times investors would be willing to pay over a company's net income.
If the P/E ratio is 10x, investors would effectively be paying 10 times the company's earnings to own the company. There are two ways to calculate the P/E ratio:
- Market Capitalization/ Net Income
- Share price/ Earnings per share
The EV/EBITDA ratio stands for enterprise value to earnings before interest, taxes, depreciation & amortization. Enterprise value includes the value of equity and the value of debt.
Many people consider the enterprise value to be a more accurate value of the firm's value because it considers the firm's debt obligations.
A benefit of using EBITDA over net income is that you'd be able to see the total earnings potential of a company because net income can be quite distorted due to accounting techniques.
For example, depreciation and amortization is simply accounting method used to spread the life of an asset across multiple years. However, there is no real outflow of money, hence the distortion of net income.
- The comps analysis is one of the 3 major valuation techniques used by many front office roles in finance. The other two are the discounted cash flow model and precedent transaction analysis.
- Generally speaking, the comps analysis follows a relative valuation approach instead of a fundamental valuation approach. While it doesn’t try to determine the target’s intrinsic value, it assumes that a target should have a similar valuation to its peers.
- A key benefit of this valuation technique is that it is realistic. It indicates the price that investors would generally be willing to pay instead of a theoretical price derived from multiple assumptions.
- There is more than one multiple that analysts can use when executing this analysis (P/E, EV/EBITDA, etc.). Although there is no hard and fast rule behind which multiple is ideal, there are some differences between each multiple.
- Lastly, while the comps analysis is helpful, it should not be the only valuation technique analysts use. Instead, analysts should think of the comps analysis as a benchmark valuation rather than a quintessential value that the company should trade at.