Comparable Companies Analysis
How Does Comparable Companies Analysis Work?
Comparable Companies Analysis, often termed 'Comps Analysis', is another valuation methodology where instead of projecting and analyzing a company's cash flows as you would do in a DCF Analysis, you compare the company to other similar public companies and apply the valuation multiples from those peer companies to value the one you're looking at. Comps Analysis operates under the assumption that similar companies have similar valuation multiples, such as Enterprise Value-to-EBITDA multiple or Price-to-Earnings ratio. For example, assume you are trying to value a company with an EBITDA of $50 million. If similar companies (in the same sector with similar risk and growth profiles) are trading at Enterprise Value-to-EBITDA multiples of between 15x and 20x, then the technology company you are valuing should, in theory, have an Enterprise Value of between $750 million ($50 million * 15) and $1 billion ($50 million * 20). If the current Enterprise Value of the company is above $1 billion (i.e., multiple is above 20), it means that the market could be overvaluing the company. By the same token, if the company's current Enterprise Value is below $750 million (i.e., multiple is below 15), it means that the market could be undervaluing the company. While this method is clearly less rigorous than a DCF Analysis, it can be helpful to use it to cross check your DCF Analysis results.
How Do You Perform Comps Analysis?
1. SELECT PEER COMPANIES: The first step to performing a Comps Analysis is to, unsurprisingly, select the appropriate set of comparable public companies. This selection is critical and can have a significant impact on the valuation of your target company. Some good selection criteria to consider include: Industry (What kind of company is it? What sector does it operate within primarily?), Geography (Where is the company based? Does it operate any international offices or branches?), Size (How much revenue does the company earn? How many employees does it have?), Growth Rate (What stage is the company currently at? How quickly is it growing?), etc. A good approach is to start with a broad set of companies and then slowly filter out the less relevant ones. Ideally, you would want to end up with a set of between 5 to 10 comparable companies.
2. CHOOSE METRICS AND MULTIPLES: After determining your set of peer companies, the next step is to select the metrics and multiples you want to use. Multiples are the ratios you calculate, such as Enterprise Value/Revenue (EV/Revenue) or Price/Earnings (P/E). Metrics are the denominators in your multiples, such as Revenue, EBITDA, and Net Income. There is no 'correct' or 'best' metric, each have their relative strengths and weaknesses. The important thing to note is to make sure your metric pairs with the right numerator (see Equity & Enterprise Value page for more information on metric pairing). When performing a Comps Analysis, you can choose to use trailing (i.e., historical) performance metrics or future (i.e., projected) performance metrics or a mix of both. Trailing metrics, such as Last Twelve Months (LTM) Revenue, are useful because they are based on real events, but a problem with trailing metrics is that they may also be distorted by non-recurring one-time items such as acquisitions. Future metrics, such as next year's projected revenue, are useful because they assume that the company will operate in a 'steady state' without any unusual events or non-recurring items, but they are also less reliable since they are based on assumptions and may be subject to pitfalls associated with forecasting. Generally, you should target to have 2-3 metrics.
3. SPREAD COMPS: The third step in performing a Comps Analysis is to spread (calculate) the various metrics and multiples for the companies selected in step 1. Since you use only public companies, the calculations are fairly straightforward. You calculate each company's current Equity Value and Enterprise Value based on the company's current Share Price, total number of shares outstanding, and most recent Balance Sheet (see Equity & Enterprise Value page to learn how to calculate Equity and Enterprise Value). For your metrics, you can retrieve the historical figures for Revenue, EBITDA, Net Income, and any other metric by going through the company's annual and quarterly reports, and you can find projected figures in equity research reports or other sources. Once you have all the necessary values, you simply divide each of your peer company's Equity or Enterprise Values by each metric to determine your range of multiples. Note that you always use a company's current Equity Value and Enterprise Value – there is no such thing as projected Equity or Enterprise Value because a company's Share Price already reflects investors' expectations about its future performance (it is already making a projection).
4. APPLY MULTIPLES TO TARGET COMPANY: Once you have your range of multiples, the final step is to value your target company based on that range. Typically, you calculate the median of each multiple for your peer companies and then apply that median multiple to your company. For example, if the median LTM Enterprise Value / Revenue multiple for your comparable companies is 10x and the LTM EBITDA of the company you are valuing is $40 million, then your company's implied Enterprise Value is 10 * $40 million = $400 million. You can then compare this calculated implied Enterprise Value to the current Enterprise Value of your target company to determine whether it is being potentially overvalued or undervalued by the market.
Pros & Cons of Comps Analysis
Less dependent on assumptions compared to DCF Analyses
Based on actual market data and reflects value according to current market trends
Quick and easy to calculate with data widely available
Reflects industry trends and growth prospects
May be difficult to find truly comparable companies, since every company is different
Dependent on market views, and may be influenced by temporary market conditions or non-fundamental factors
Does not work well if comparable companies are volatile