What Is Comparable Company Analysis?
Comparable company analysis is a method used by investors looking to discover undervalued companies. Comparable company analysis, or CCA, groups together very similar companies and compares them using price multiples.
Why Use Comparable Company Analysis?
CCA is used by investors who believe that similar companies should be similarly valued. To start the process of comparable company analysis, investors must first find a group of very similar companies. Next they must calculate several price multiples such as the price to earnings ratio, price to book ratio, and price to sales. Next the investor must compare these price multiples to get an idea of which company is over valued and which are under valued. In theory, the company with the highest price multiples is overvalued and vise versa. This method of valuation is believed to give investors a general understanding of value as opposed to other methods.
Using Transaction Multiples
Another way investors use CCA to gain a general idea of valuation is by analyzing previous company transactions. By analyzing previous acquisitions of companies, investors can gauge what multiples companies in a particular industry typically sell for. In theory, a company who is purchasing another company will most likely pay a fair price. This is because companies typically rely on advice from banks or other financial professionals to understand what price they should pay. Investors who analyze these transactions can gain an understanding of what price multiple similar companies should be trading at.
Limitations Of Comparable Company Analysis
While comparable company analysis is a good start for investors looking to gauge value in a general sense, it lacks the precision other valuation methods have. Price multiples, for example, are not fool proof metrics for valuation. In theory, companies trading for high multiples are likely overvalued. However, price multiples do not factor in key factors such as intangible assets, future growth, or financial health, all of which may justify a higher multiple. Because CCA relies so heavily on price multiples, it lacks specification for individual companies. CCA is also only effective when used for very similar companies. Using CCA across industries is useless and even within the same industry, the companies being compared must be very much alike.
Example Of Comparable Company Analysis
Let’s suppose an investors is looking to invest in a car company. The investor first makes a list of 3 companies. Next, they calculate several key price multiples for each of the companies. Their list is below.
Company A: (PE Ratio, 14x) (PB Ratio, 2.5x) (PS Ratio, 3x)
Company B: (PE Ratio, 9x) (PB Ratio, 1.8x) (PS Ratio, 2.3x)
Company C: (PE Ratio, 17x) (PB Ratio, 3.4x) (PS Ratio, 4.2x)
After making this list, the investor concludes that Company B is the cheapest car company available. As you can see by this investors analysis, comparable company analysis is not very thorough or in depth.
Effectively Use CCA
While CCA may not be perfect, it can certainly be improved. As stated before, one limitation of CCA is price multiples not factoring in certain factors. However, investors can improve this by only comparing the most similar companies possible. It is important that investors look past basic things like industry and products when looking for similar companies. Instead, investors should build upon this process by factoring in things such as age, growth rate, size, and capital structures to ensure that they are only comparing the most similar companies possible.
Which Multiples Are Appropriate For CCA?
Of course, it is important which price multiples an investor uses to gauge relative value. However, it would be wise to make this decision on a case to case basis in accordance with the specific situation. For example, when comparing young companies which are not yet profitable, it would be a waste of time to using an earnings multiple. Instead, investors may choose to use a revenue multiple such as EV-Revenue. The bottom line is that, as with everything in CCA, it is vital that investors carefully choose which multiples to compare.
