5 Important Reasons to use Comparable Company Valuation
When you're trying to figure out the value of a company, one of your first stops should be to compare it with other companies in its industry. The reason is simple: if you have two companies that are similar in size and scope, they'll have similar risk profiles and similar growth potentials. By comparing them, you can better understand what your company might be worth.
This blog introduces the concept of comparable company valuation and explains how it can be used to estimate the value of a business.
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What is Comparable Company Valuation?
Comparable company valuation is a method of valuing a company by examining the value of similar companies in the same industry. It is based on the notion that businesses with comparable characteristics should have similar values. By analyzing financial statements and other metrics, you can identify similar companies and use their market values as a benchmark for determining your business's value.
The idea is that if you can find a group of companies with similar market values, financial characteristics, and growth prospects, then you can apply those multiples to your own company's financials to come up with an estimated valuation.
Why Comparable Company Valuation is Important?
There are several reasons why analysts use comparable company valuation as a tool for determining the value of a business:
It provides a benchmark for determining whether a stock is undervalued or overvalued. If the stock price is below its estimated fair market value, then it may be a good investment opportunity. On the other hand, if the stock price is much higher than its estimated fair market value, then it may be overvalued and not worth buying.
It allows investors to compare different companies within the same industry or sector, which helps them determine which stocks are more attractive investments than others.
For example - If one company has lower growth prospects than another but has been growing faster over time due to better management or better performance of its products/services in that sector, it might be worth paying more money for that stock because it appears to have brighter prospects than its competitor.
It's quick and easy – The process doesn't require much time or effort, making it great for those who don't have much experience with valuation methods.
It's simple – The process doesn't require any advanced knowledge of accounting or finance, making it suitable for beginners as well as experts alike.
It's flexible – You can easily adapt it to suit your needs by changing certain variables such as industry type or size range used when looking for comparable companies.
Types of Comparable Company Analysis
Here are two types of comparable company valuation:
Benchmark analysis— This is the most basic type of comparable company valuation. In this case, you look at the current market value of your business and compare it with other similar businesses.
For example - If your business has a $10 million market value but similar companies have market values ranging from $5 million to $15 million, then you could conclude that your business might be worth somewhere between $5 million and $15 million.
Transaction analysis— Transaction analysis looks specifically at how much money was paid to a company during an acquisition or merger. This helps provide insight into how much buyers were willing to pay for similar businesses in the past — which can help determine what they might pay for yours today.
Formulas Used for Comparable Company Valuation
Enterprise Value is the total value of a company. It's calculated as the market capitalization plus debt, minority interest, and preferred shares, minus total cash and cash equivalents.
The Enterprise Value is often used in the context of mergers and acquisitions to determine the overall value of a company.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of profitability used by investors and analysts to compare a company's performance from period to period without the effects of financing, accounting, and tax decisions.
EBITDA is used to figure out how much money you have left over after all expenses are paid. It can be used as a gauge of business health because it excludes the cost of financing and accounting decisions (such as depreciation). EBITDA is also used in M&A transactions because it allows buyers and sellers to compare operating results more easily across companies.
Ratios Used for Comparable Company Valuation
EPS (Earnings Per Share)
It is calculated by dividing Net income less preferred dividends by the total number of shares. If a company’s EPS is greater than its peers’, then its stock price should be higher than theirs. This can be done by calculating an average EPS for all companies in an industry or sector, then comparing each company's EPS with that average.
How to Perform Comparable Company Analysis?
There are two different ways to perform a comparable company valuation: relative and absolute.
The relative approach compares your company's metrics with those of other publicly traded firms in your industry.
The absolute approach compares your company's metrics with competitors outside your industry. The Comparable Company Valuation process consists of 4 steps:
1 - Identify a set of comparable companies that are like your company.
2 - Collect information about the selected companies. Determine the valuation range for each comparable company based on their relative financial performance and other factors.
3 - Calculate ratios for each company. Take an average valuation for each comparable company and use this average as the basis for valuing your own business or company.
4 – Determine whether any adjustments need to be made. Calculate final estimates of value with the help of multiples.
Advantages of Comparable Company Valuation
It allows investors to compare multiple private companies at once.
It reduces reliance on "gut feel" or subjective judgments because it relies on quantifiable financial data.
It minimizes errors by using objective benchmarks.
It is easy to understand and apply. The method is also easy to explain to investors, employees, and other stakeholders.
It is flexible enough to be applied to a wide range of business situations and industries.
It can be used by analysts who have limited financial knowledge but with good analytical skills and experience in the industry being analyzed.
Comparable company valuation is less risky than DCF and LBO models because it does not require forecasting future cash flows and discount rates, which are subject to changing market conditions.
Disadvantages of Comparable Company Valuation
Influenced by temporary market conditions or non-fundamental factors.
Not useful when there are few or no comparable companies.
Can be difficult to find appropriate comparable companies for various reasons.
Less reliable when comparable companies are thinly traded.
Comparable company valuations often require a large amount of work and time. The analyst needs to spend considerable time researching similar companies and comparing their financial statements with those of the target company to estimate its value accurately.
Inconsistency of data collection methods
There are many ways that analysts can collect data about transactions between comparable companies and this means there will likely be inconsistencies between them.
For example, if one analyst uses EV/EBITDA multiples while another analyst uses EV/Sales multiples (or some other type), they will get different numbers even if they are looking at the same company.
When undertaking a project to value the shares of a company, it is important to understand the methodologies used by industry professionals. It is quite easy for a business owner to be swayed by the words and opinions of others, as an investor or lender. When looking at comparable companies, two questions should be asked: how comparable are these businesses, and how does my business compare to those analyzed?
A comparable company analysis is an effective way to identify potential upsides and downsides to a potential investment. It is time-consuming and requires diligence but using a comparable company analysis can help minimize the risk of a potential investment.
Comparable company analysis requires a screen for companies that are like the ones being valued. Multiples are calculated based on enterprise value and a company's trailing twelve months’ revenues, EBITDA, or net income.
Once you've identified comparable companies and have their valuations and multiples, take an average of the valuation number. This is your comparable company value.
Use the industry average as your comparable company value.