Market Approach Comparable Company Analysis – Basic Steps for a Defensible Valuation Estimate`

Performing a Market Approach Comparable Company Analysis involves carefully examining financial statements and market data. This process requires attention to detail and a strong understanding of financial concepts. You will need to use various tools and techniques to analyze income statements and identify companies that are comparable to the one being evaluated. The goal is to select peer companies, closely examine their financial metrics, and determine a value that is grounded in factual data. While this task can be challenging, having the right skills and using spreadsheets effectively will guide you through the process. Welcome to the essential task of comparable company analysis.

 

What Is the Market Approach: Comparable Company Analysis for M&A Valuation?

The market approach helps assess the value of a company by analyzing comparable public companies. This involves identifying similar companies and deriving valuation multiples from their trading prices to apply to the target company. It provides a market-based perspective on value.

When using the market approach for M&A valuation, follow these key steps:

  • Select a group of publicly-traded companies that are similar to the target company in terms of industry, business models, growth rates, size, profitability, etc. The more comparable, the better.

  • Gather key financial data for each company – revenue, EBITDA, net income, etc. – and calculate relevant valuation multiples like P/E, EV/EBITDA, P/S, P/B etc.

  • Compare ratios across the peer group to identify outliers. Exclude companies with unusual financial performance. Calculate medians rather than means to limit impact of outliers.

  • Apply multiples from comparables to the target company’s financial metrics to estimate its value. Adjust multiples for differences in growth, profitability, size etc. between target and peers.

  • Apply qualitative judgment. Consider soft factors impacting the target’s value like quality of management, competitive position, barriers to entry etc. Adjust valuation accordingly.

  • Conduct sensitivity analysis around key assumptions. Vary growth rates, profit margins, multiples etc. within a reasonable range to assess impact on valuation.

  • Weight market approach valuation appropriately with other methods like DCF analysis or precedent transactions approach. It provides a market reality check.

The market approach offers a straightforward way to value a company based on current market pricing. With careful peer selection and prudent adjustments, it can provide a reliable indication of value. Combining it with other approaches leads to a balanced perspective for negotiations.

 

Step One: Select the Universe of Comparable Companies

The first step is to identify which companies to include in your comparative analysis. This is easier said than done. You want to cast a wide net initially, then narrow your focus to the most relevant comparables.

  • Start by screening for companies in the same industry and/or companies that provide similar products or services. These will share common characteristics and face similar market conditions as your target company.

  • Look at companies with comparable business models, growth rates, profit margins, return on assets, etc. The more similar the financial metrics and performance, the better.

  • Consider companies that compete for the same type of customer or operate in similar geographic markets. Shared end-markets indicate greater comparability.

  • Don’t limit yourself to the target’s immediate peer group. You may find good comps outside the target’s core industry. For example, a pharmaceutical company can be compared to biotech firms though they are not perfect peers.

  • If the target company operates across multiple business segments, try to identify companies that mirror the revenue mix. No single comparable may match perfectly, so you may need to blend multiples from several companies.

  • Screen for companies of roughly similar size in terms of market cap, assets, revenues, etc. Size correlates with growth prospects, risk, capital structure, etc.

  • Only include companies with sufficient public financial data for meaningful comparison. This typically requires at least two years of historical financials.

  • Aim for a list of 8-15 potential comparable companies to start. You can always eliminate weaker comparables later. Too few comps increases the risk of skewed or unreliable multiples.

Cast a wide net when compiling your initial universe of comparable companies. Look across industry lines to find companies with similar operating metrics and market traits. The goal is to identify companies facing comparable opportunities and challenges as the target company.

 

Step Two: Locate the Necessary Financial Information

  • You must dive into a company’s financial statements to extract the data needed for comparable company analysis. This information allows you to evaluate operational and financial performance.

  • The most critical filings are the 10-K annual report, 10-Q quarterly report, and 8-K special disclosures. You can find these SEC documents on the company’s investor relations website or on EDGAR.

  • Registration statements like S-1 are also useful to understand a company’s historical performance and future projections. The risk factors section outlines key business challenges.

  • Gather 5 years of historical financials from the income statement, balance sheet, and cash flow statement. Focus on revenue, EBITDA, EPS, debt, cash, capital expenditures, etc.

  • Leverage data aggregators like Bloomberg, S&P Capital IQ, Pitchbook or TagniFi to quickly compile financials if you lack the time to dig through filings.

  • Standardize accounting policies if needed. For example, lease accounting changed under ASC 842. Recast financials under the new standard for an apples-to-apples comparison.

  • Carefully comb through footnotes and MD&A for critical details on restructuring charges, divestitures, pensions, etc. that impact financial performance.

  • Evaluate key operating metrics like same store sales growth, subscriber figures, ARPU, etc. featured in earnings releases and conference call transcripts.

  • Research equity reports from Wall Street analysts for additional color on financial performance. Reports outline historical results, provide earnings estimates, and assess valuation.

  • With diligence and patience, you can amass the detailed financial information required to successfully execute comparable company analysis. Let the numbers tell the story.

 

Step Three: Spread Key Statistics, Ratios, and Trading Multiples

At this stage, the real analysis begins. We’ve navigated through extensive financial data – examining balance sheets filled with assets and liabilities, and income statements detailing revenues and expenses.

Now, it’s time to focus on the key statistics, ratios, and trading multiples we’ve collected. This step involves a detailed examination and interpretation of these figures. We need to analyze each statistic and ratio thoroughly, understanding its implications from various perspectives.

  • Look at the profitability ratios – net profit margin, return on assets, return on equity. What story do they tell about the company’s ability to generate income from its operations?

  • Consider the leverage ratios – debt-to-equity, interest coverage. Do they suggest a risky debt load or reasonable financial health?

  • Examine the liquidity ratios – current ratio, quick ratio. Are they high enough to meet short-term obligations? Low enough to avoid excess idle capital?

  • Review any other supplemental ratios and statistics – inventory turnover, receivables turnover, working capital, capital expenditure, R&D spending. What insights emerge?

Once we have closely examined each financial metric, it’s time to organize them along with the essential trading multiples, such as P/E, P/B, EV/EBITDA, EV/REVENUE.

Think of it as piecing together a puzzle. We’ve collected all the necessary information. Now, we need to analyze how these elements interact with each other to draw informed conclusions about the company’s true valuation.

There’s more to do in this process, so let’s continue with our analysis.

 

Step Four: Benchmark the Comparable Companies

You’ve identified and analyzed the key comparable companies. Now it’s time to benchmark their financial statistics and trading multiples against the target company. This helps you gage where the target sits relative to its peers.

  • Gather the relevant ratios and multiples for each comp. Focus on those most relevant for valuation like P/E, EV/EBITDA, P/B, etc.

  • Calculate the median, minimum, and maximum value for each metric across the peer group. This provides goal posts.

  • Compare the target company’s ratios and multiples to the peer benchmarks. How does it stack up? Better or worse?

  • Consider the reasons for any outliers among the comparable companies. Company or industry specifics?

  • Identify any large gaps between the target and comparable medians. What factors could explain this? Risks? Growth?

  • Don’t rely on just one metric. Look at a basket of key ratios and multiples to get a balanced perspective.

  • Keep an eye out for any comparable companies that seem poorly matched based on this peer benchmarking. You may need to revisit your comp selection.

This quantitative benchmarking allows you to objectively judge the target company versus alternatives that investors might consider. It arms you with numerical support when assessing the appropriate valuation multiples for the target.

Of course, the reasons behind the numbers also matter. Supplement this quantitative peer benchmarking with an informed qualitative assessment. Consider growth trajectories, profitability, risks, and other factors that deepen your insight into the target’s standing.

With both quantitative metrics and qualitative context in hand, you have a solid foundation for determining reasonable valuation estimates. The peer benchmarking provides you with guideposts and reveals how the market values similar companies. Use this to build up your valuation model judiciously.

 

Step Five: Determining Relative Valuation Multiples

You’ve successfully created a list of comparable companies and computed their key valuation multiples. The next crucial step is to interpret what these multiples suggest about your company’s potential valuation. This phase involves a combination of analytical skills and informed judgment.

  • First, you’ll want to calculate the median or average for each multiple across the peer group. This gives you a solid benchmark to compare against. But averages can be skewed by outliers, so also look at the range and distribution.

  • Next, think critically about each comparable company. Are there reasons why your company should trade at a premium or discount to certain peers based on growth, profitability, or risk? This is where your business judgment comes in.

  • You may decide to apply different multiples for different segments of your business. For example, maybe your software division warrants a higher revenue multiple than your services division. Get creative in your analysis.

  • Consider triangulating multiples. If EV/EBITDA, EV/Revenue and P/E ratios tell a consistent story, you can have more confidence in the implied value range. If they diverge, dig into why.

  • Run sensitivities on your assumptions. How does the valuation range shift if you adjust the multiples up or down by 0.5x or 1x? Pressure test your conclusions.

  • Lastly, weigh the implied valuation ranges from comparable companies against other approaches like DCFs or precedent transactions. Look for convergence and corroboration across methodologies.

The key is to use multiples as a tool, not a formula. Let the comparables guide you, but ultimately rely on your own informed judgment of what your company is worth. The market approach comparable company analysis is art, not science.

 

Step Six: Making Quantitative Adjustments to Multiples

Making quantitative adjustments to the multiples allows you to account for differences between the comparable companies and the target company. This helps yield an apples-to-apples comparison.

  • First, adjust for size differences. Larger companies often trade at lower multiples than smaller companies, as they are perceived as less risky investments. To adjust for size, you can scale the multiples up or down based on the relative size difference.

  • Next, adjust for non-operating items like excess cash, non-operating assets, or unusual expenses. Remove these from the equation to isolate the true operating performance.

  • Also adjust for one-time events or non-recurring items that may skew the metrics for a given year. Normalize the financials to get a clear picture of the core business.

  • Then, account for different growth rates. Faster growing companies merit higher multiples, so adjust up or down accordingly based on growth rate deltas. Use revenue or earnings growth rates over a 3-5 year horizon.

  • Finally, adjust for different capital structures. Companies with higher levels of debt tend to trade at lower multiples. To adjust, use the relative weights of debt and equity to modify multiples.

Making multiple small adjustments through this process, rather than one large blanket adjustment, allows for greater precision in the analysis. The goal is to carefully calibrate the multiples to ensure an apples-to-apples comparison between peers. With sound quantitative adjustments, you can derive a valuation range that accurately reflects the target company’s intrinsic value.

 

Step Seven: Applying Valuation Multiples to Estimate Value

Once you’ve identified and calculated the relevant valuation multiples for your set of comparable companies, it’s time to apply those multiples to the target company’s financial metrics to estimate its value. This involves a few key steps:

  • Select the most relevant valuation multiples from your analysis in Step 6. Focus on multiples like EV/Revenue, EV/EBITDA, P/E, etc. that make sense for the target company.

  • Identify the appropriate historical and projected financial metrics for the target company – revenue, EBITDA, net income, etc. Make sure to use the metrics that align with the multiples you selected. The projections are key here.

  • Apply the median or average multiples from the comparable set to the target company’s metrics. For example, if the average EV/Revenue multiple was 5x, multiply the target’s revenue by 5x.

  • Apply multiples to both historical and projected financials. This will give you a range of potential valuation estimates. Weight the projections more heavily, as value is inherently driven by expectations of future performance.

  • Run the calculations for each relevant multiple and financial metric combination. Summarize the implied valuation ranges based on medians and averages. Include minimum and maximum ranges.

  • Consider adjusting the multiples up or down based on the target company’s growth outlook, margins, and other metrics compared to the peer set. If growth expectations are higher, tilt toward higher multiples.

  • Cross-check the overall valuation ranges implied by the comparable company analysis against other valuation methods like DCF analysis. Look for clustering and consistency.

  • Aim for a valuation estimate that synthesizes the various multiples and methods into a justifiable range. Document the analysis thoroughly to support it.

The key is to utilize reasonable judgment when applying multiples in order to estimate a sensible valuation range, supported by diligent analysis of quality comparable companies. Let the multiples tell a data-driven story.

 

How Can Eton Help?

At Eton Venture Services, we understand the complexities and nuances of mergers and acquisitions. Our dedicated team of legal and finance talent, specializing in business  and M&A valuation, delves into your company’s financial data with precision and care. We ensure that every valuation report we produce is not only accurate but also presented in a format that is clear and easy to understand. This approach is crucial in helping you achieve the best possible outcome from your M&A transaction.

Connect with us at Eton for a detailed consultation tailored to your needs. Whether you have specific questions or require comprehensive support, our team is ready to assist. Additionally, get a glimpse of your business’s current performance with our interactive tools. Contact Eton today for expert guidance in M&A valuation.

 

Market Approach: Comparable Company Analysis FAQs: Answering Common Questions

Comparing a company to its peers can provide useful insights into valuation. But how does this analysis actually work? Let’s walk through some frequently asked questions:

What is Market Approach Comparable Company Analysis?

Market approach comparable company analysis looks at similar public companies to estimate the value of a target company. The key is to compare “apples to apples.” You select companies in the same industry, with similar products, customers, size, growth, margins, etc.

Start broad and narrow down. Screen for industry, geography, size, profitability, products, and business model. Pick companies with similar risk, growth, capital structure, and performance. Exclude outliers. Aim for a representative peer group of 8-10 companies.

  • What are the steps in performing Comparable Company Analysis?

  • Select your comparables

  • Calculate valuation multiples like P/E, EV/EBITDA

  • Determine appropriate multiple ranges based on growth, risk, etc.

  • Apply multiple ranges to your target company’s metrics

  • Derive valuation estimates from this

  • What are the commonly used valuation multiples in this analysis?

Common multiples are Price/Earnings (P/E), Enterprise Value/Revenue (EV/Revenue), Enterprise Value/EBITDA (EV/EBITDA), and Price/Book Value (P/BV). Multiples capture how much investors are willing to pay for earnings, cash flow, book value, etc.

No companies are perfect peers. Each has unique strategy, products, growth, risk, etc. The analysis depends heavily on current market sentiment. Outlier multiples can skew results. It provides a general valuation range, not an exact value.

Comparable Company Analysis gives a ballpark valuation estimate. Use it along with other methods like DCF analysis and precedent transactions. The peer group should be carefully selected. Apply multiples judiciously based on company-specific factors.

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President & CEO

Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.

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