Comparable Company Analysis

Comparable Company Analysis

An image of a computer screen showing comparable company analysis.

Key Takeaways About Comparable Company Analysis:

This guide explains what comparable company analysis is, how it works, and its place in the valuation of a privately held business. We’ll start off with some key takeaways and move into deeper explanation as the guide progresses. Here are some key takeaways about comparable company analysis:

  • Comparable company analysis is a method of valuation commonly used to assign value to a business.
  • Comparable company analysis looks at the value of publicly traded companies that are similar to the business we’re trying to value and assigns value to the business based on market data.
  • Comparable company analysis is a form of relative valuation—meaning that it attempts to assign value to the business based on what other companies are worth.

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Understanding Comparable Company Analysis:

Comparable company analysis is a method commonly used to value private companies. This method involves looking at similar, publicly traded companies and observing what they are trading at above or below earnings. As an example, if we find that Company A is trading at 7.5 times earnings, then we could use that 7.5 multiple to justify a price for the business we’re trying to value. There’s more to comparable company analysis than this, but this is an excellent high-level explanation of the concept. To go deeper into this valuation method, we’ll need some more context first.

If you’re not familiar with business valuation, we recommend our guide: Intro to Private Company Valuation as a good primer to this guide. Normally, when we’re trying to value a business, we’re not looking for our valuation method to give us an exact price. Instead, we’re looking to establish a range of values that might make sense to pay for a business. Additionally, we want to use a variety of valuation methods that each attempt to value the business from different perspectives.

Often, the end result of business valuation is a football field chart. This chart puts the valuation ranges from multiple valuation methods side by side for comparison purposes.

Here’s why this range of values is important. In the M&A process, normally a valuation of the target business is performed before negotiations begin. During these negotiations the seller is trying to justify the highest price possible for their business and the buyer is trying to get a deal done at the lowest possible price the seller will accept. We conduct valuations like this because we understand that in the M&A process, we will need to be able to argue and make a case for why we want to offer this amount (buyer’s perspective), or why we deserve to get this amount (seller’s perspective).

Additionally, a huge reason why M&A deals are looked at as failures is that the buyer overpaid for the business and couldn’t realize a return on the transaction.

There are four main methods of private company valuation:

The discounted cash flow method is a type of intrinsic valuation method. Here we look at the business from the perspective of its ability to produce future cash flows. This valuation method takes the values of these future expected cash flows and discounts them back in time to their net present value. This is an attempt to show us what it would be worth paying today for those cash flows to be received in the future. So, this valuation method values the business based on its future cash flows.

The asset valuation method gives us a valuation of the business based on the fair market value of the net assets the business has. This method doesn’t take into account cash flow or profitability at all. This valuation method only gives us a valuation of the business from the perspective of what its net assets are worth.

The other two methods, comparable company analysis and precedent transactions, are forms of relative valuation. Here, we’re attempting to value a business relative to what other similar companies are worth.

The precedent transactions method looks at data from merger and acquisition deals and gives us a way to value a business based on past transactions. Here, we will look at what a similar business, of a similar size, in the same industry sold for above earnings. Then during a negotiation, we can make a case that our business is worth the same amount above earnings because another buyer was willing to pay that for a similar company.

Comparable company analysis is somewhat similar to the precedent transactions method because they are both forms of relative valuation. However, comparable company analysis is different. Here we use publicly traded companies for our comps instead of looking at past M&A deals.

With comparable company analysis, we go to the stock market and we find companies that are similar in size, with similar business models, in the same industry, and we look for financial metrics. The most common of these metrics is price to earnings. This shows us what those companies are trading at (in the open market) above or below their earnings. So, we are able to make a case that our company is worth a similar amount because all of the investors that own shares of that publicly traded company are buying and selling shares on the open market to support that price.

Mistakes To Avoid With Comparable Company Analysis:

Now that we understand comparable company analysis and how it fits into our valuation of a privately held business, we’ll look at some common mistakes made with this valuation method.

At the end of the day, remember that with comparable company analysis, we’re comparing the metrics of similar businesses that are a similar size, and operate in the same industry. If the business we’re comparing to isn’t similar, then this valuation won’t make any sense.

Additionally, we can make a much stronger case if we have more than one comparable company to compare our valuation to. As an example, we have Company A, which is trading at 7.5 times earnings. We can certainly make the case that our similar business is worth that amount to. We could make a much stronger case if we had more data, however. If Company A trades at 7.5 times earnings, Company B trades at 8.5 times earnings, and Company C trades at 8 times earnings, then we can make a case that our company is worth 8 times earnings and cite that we’ve taken an average of the three companies to arrive at that conclusion. This is a much stronger case because we have more data to back up our argument.

Another common mistake made with comparable company analysis is not accounting for the liquidity premium. To make this concept as simple to understand as possible think about it from the investor’s perspective. If you had a choice to invest in shares of a publicly traded company or to buy a minority ownership stake in a privately held business—each of which promised the exact same return—which, would you choose? All things being equal, a savvy investor would pick the publicly traded company, because the shares are more liquid. It’s easy to sell shares of a publicly traded company during any normal trading hours. It is much more difficult to sell a stake in a private company. So, we have to assume when we’re doing comparable company analysis that our valuation will be higher for that public company than it will be for our private company. In valuation, this is called a liquidity premium. To account for this we apply a liquidity discount, where we take the valuation down to reflect this difference in liquidity between the comparable company and ours.

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