How to Choose Comparable Companies
The basis of comparable company analysis.
Updated November 27, 2018
How to Choose Comparable Companies
Choosing a fixed of comparable companies – a comparable population – is the first and most authoritative step to comparable company analysis. The rest of your analysis and evaluation is based on the stage set of comparable companies you identify at the begin of your psychoanalysis. therefore, it is authoritative to make certain that you choose the right comparable universe, otherwise, you risk invalidating your valuation and all the solve you put into developing your model.
Reading: How to Choose Comparable Companies
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There are multiple factors that decide whether a company is a good comparable ship’s company for your model. generally, when fiscal analysts select comparable companies, they are looking for firms that are most like to the ship’s company they are trying to value. The intuition behind this is that if investors are volition to pay a certain total for a exchangeable caller, they should be willing the pay that same sum for the company that we are trying to value. The first thing a fiscal analyst should do is find the company they are valuing on Bloomberg or CapitalIQ. This will allow them to get a description and industry classification of the firm. 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
diligence classification is an important factor when choosing comparable companies. Starting with a company ’ second diligence will help an analyst find exchangeable companies, as companies in an industry often operate similarly. There are many resources such as Bloomberg ’ s Industry Classification System that a fiscal 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 case, 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 lapp industry. In line, even though it is besides an automotive company, Aston Martin would not be a good option 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 alike size profiles to the company you are trying to rate. This could be a comparison based on tax income, assets, count of employees, or other factors. Though an extreme example, we can look at Activision Blizzard Inc. to explain why size is authoritative. Activision Blizzard had a market capitalization of US $ 63 billion as of October 2018, an annual gross of US $ 7 billion in 2017, and employs over 10,000 people. The company operates on a boastfully, ball-shaped scale. therefore, It would not be appropriate to use Activision Blizzard as a comparable company for an mugwump video game studio that has a team of 30 employees, since the two companies operate on wholly different scales .
A key to finding comparable companies is similarity in operations. In this sense, geography is besides a consideration to look at when selecting your comparable population. different regions have unlike consumer demographics, consumption polish, legal restrictions, and necessitate for products. A tauten that exists in North America may not inevitably be successful in Asia if it does not change its intersection or the means it operates. consequently, geographic region has an effect on the comparison of a firm. Learn more about comparable ship’s company analysis and valuation techniques in CFI ’ south Business Valuation Course !
Investors pay attention to growth projections and growth rates to determine the measure of a caller. If two companies were completely identical except for increase rate, the company with a higher increase 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 recipe is as follows :
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Where : We can hold the follow values ceaseless and lone transfer the increase 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 prize of $ 500,000. A emergence rate of 5 % produces a terminal value of $ 200,000. It is net with this calculation that the emergence rate of a company wide influences the measure that investors see in it. therefore, it is imperative for an analyst to find comparable companies with like growth profiles for their comparable universe .
It goes without saying that a firm ’ s profitableness affects its respect to investors. Like with increase rate, we can look at two firms, firm A and Firm B, that have like operations and capital structure. If both firms earn alike gross but Firm A has higher margins, firm A will be valued higher. Higher margins are an indicator of fiscal performance. With greater margins comes greater net income and more opportunities to invest in growth or issue dividends to investors. If an analyst selects firms that have widely unlike margins for their comparable universe, they risk throwing off their evaluation as they are no longer using firms that have the same expectations of value. Therefore, profitableness is an important measured for an analyst to pay attention to when selecting comparable companies. If you are looking to brush up on your evaluation skills, CFI ’ s Financial Modeling & Valuation Analyst ( FMVA ) ™ certificate platform can help you become a first fiscal analyst !
finally, capital structure is another key retainer 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 sheath of bankruptcy. If a company declares bankruptcy, its assets go towards paying back debtholders first. entirely after debtholders ’ claims are settled do fairness holders have a probability 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 revert because of the gamble they face when a party is financed with more debt. As a solution, a ship’s company with higher leverage typically trades at a discount. A fiscal analyst should pay attention to the capital social organization of the firms they are evaluating when selecting comparable companies. This way, the comparables evaluation 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 adequate companies for a fiscal analyst to filter through if they use every single standard we have listed. sometimes an analyst will have to use fewer standard, other times they may use more. It is authoritative for an analyst to consider what factors are most important when valuing the caller they are analyzing.
For example, if you are looking at a firm that has like growth rates, margins, capital structure, size, and geography, but it does not fall in the lapp diligence as the firm you are trying to measure, it can still be used as a comparable company. Check out CFI ’ second Business Valuation Course to learn more about the adjacent steps after choosing your comparable universe !
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