1. Selecting Comps
Just like in a DCF, we must thoroughly understand the target's business,
reviewing financial and industry reports are a great starting place.
Once we understand the target's business, we can now go through a comparable
company analysis, which consists of three steps, select an appropriate peer
group, the comps, find an interrelevant data, and finally, value the target
company using these selected multiples. Realistically, picking comps is
the most important part of a comps analysis, and where you should spend
most of your time, unless you're already a specific industry expert.
Again, the goal is to find peers with similar risk factors as the
target company. Let's go over what characteristics to look for when selecting
the best comparables. Industry; this is our typical starting point as most
comps come from the same sector. Geographical location;
ideally the comps should be in similar geographical locations, given how
different geographies will have different laws and tax rules and different
macroeconomic factors. Size and growth profiles; companies of similar sizes
often have the same risk and return profiles as well as similar multiples,
consequently differences in size often map to differences in valuation
as mentioned earlier, higher growth also typically results in a higher multiple.
Similar profitability; all else being equal, companies with higher margins
receive higher multiples. Similar accounting policies; we want to keep accounting
adjustments to a minimum so ideally, we would find companies that use similar
accounting policies. Similar capital structures; the greater the debt a
company has, the greater its risk is, therefore, we should look for companies
with similar capital structures.
2. Let's practice!