littlebook The Little Book of Valuation

What is a comparable firm?

            A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. It would be ideal if we could value a firm by looking at how an exactly identical firm - in terms of risk, growth and cash flows - is priced. Nowhere in this definition is there a component that relates to the industry or sector to which a firm belongs. Thus, a telecommunications firm can be compared to a software firm, if the two are identical in terms of cash flows, growth and risk. In most analyses, however, analysts define comparable firms to be other firms in the firmÕs business or businesses. If there are enough firms in the industry to allow for it, this list is pruned further using other criteria; for instance, only firms of similar size may be considered. The implicit assumption being made here is that firms in the same sector have similar risk, growth, and cash flow profiles and therefore can be compared with much more legitimacy.

This approach becomes more difficult to apply when there are relatively few firms in a sector. In most markets outside the United States, the number of publicly traded firms in a particular sector, especially if it is defined narrowly, is small. It is also difficult to define firms in the same sector as comparable firms if differences in risk, growth and cash flow profiles across firms within a sector are large. Thus, there are hundreds of computer software companies listed in the United States, but the differences across these firms are also large. The tradeoff is therefore a simple one. Defining an industry more broadly increases the number of comparable firms, but it also results in a more diverse group of companies.

            There are alternatives to the conventional practice of defining comparable firms. One is to look for firms that are similar in terms of valuation fundamentals. For instance, to estimate the value of a firm with a beta of 1.2, an expected growth rate in earnings per share of 20% and a return on equity of 40%[1], we would find other firms across the entire market with similar characteristics.[2]  The other is consider all firms in the market as comparable firms and to control for differences on the fundamentals across these firms, using statistical techniques.

 


[1] The return on equity of 40% becomes a proxy for cash flow potential. With a 20% growth rate and a 40% return on equity, this firm will be able to return half of its earnings to its stockholders in the form of dividends or stock buybacks.

[2] Finding these firms manually may be tedious when your universe includes 10000 stocks. You could draw on statistical techniques such as cluster analysis to find similar firms.