Comparable Company Analysis
When investing, there are a lot of ratios to consider when valuing a company. These range from profitability ratios to solvency ratios. There are general rules to each ratio (P/E: lower is better; Current: Higher is better), but how do you know if a ratio is good? The answer is simple, comparable companies analysis.
Comparable Companies Analysis (CCA) is a valuation method that looks at a bucket of companies, and compares them based on their financial information and metrics. It is one of the most common techniques used in the investment world, and helps provide a reference point to an investor to see if a ratio and company is “good”.
There are five steps in a CCA :
- Determine a list of companies to compare.
- Gather the necessary financial information.
- “Spread” key metrics and statistics.
- Benchmarking.
- Determine the valuation.
In hopes of giving a sense of how it is used in practice, we will be looking at a prospective investment of Freddy; a marketing firm.
Selecting your companies:
This is the most important step when performing a CCA. There are many ways to select these companies, however they all require a strong understanding of the target company (which company are you looking at originally). After looking at the target company and understanding its business, the next step is defining the attributes you want to use when finding the list of comparable companies. There are many different attributes that can be used when determining a list for comparing companies. They are split into two types: financial, and business.
Financial attributes include a company’s market capitalization, return on investment, or their credit profile. Business attributes include a company’s sector, distribution channels, customer and consumer database, or their geographical region.
There is no right or wrong attribute, it all depends on the purpose for a comparison. If you are looking at your target company for industry diversification, you might use sector as an attribute; while if you are looking at it for region diversification, you might use the geographical region as an attribute. You can even combine multiple attributes together!
Freddy’s:
Freddy’s is a marketing firm specializing in small scale financial services marketing. As an investor we are looking to diversify by investing in other sectors.
Knowing that we are looking for sector diversification and the target company’s sector is marketing, we will find other companies in the same space.
There are five main companies that match this criteria in your target’s region.
AntBlock: AntBlock (ABLK) is a mid-size marketing firm specializing in healthcare marketing. It has a large clientele and operates directly in Freddy’s region.
ClickWink: ClickWink (CWNK) is a small — size marketing firm that works directly with mid-scale investment advisory firms to help attract new clients. They have conducted a few campaigns in Freddy’s region.
enterNOW: enterNOW (ETNW) is a large — size marketing firm that works with governments and non — profit organizations to raise awareness and enact social change. They are heavily active but not fully operating in Freddy’s region.
GREENstripe: GREENstripe (GRNS) is a large-size firm that takes on small scale projects with local entrepreneurs and business for a much cheaper rate than the others on this list. They are across the nation and have many offices.
snapfocus: snapfocus (SNFS) is a mid — size firm that works directly with credit unions, and cooperatives. They are involved in Freddy’s neighboring regions.
With this list ready, we are ready to move onto Step 2.
Gathering financial information:
After you have chosen your list of comparable companies, this next step is relatively easy. For each company in your list, gather their financial information. You can look through their SEC filings (10K reports, 10Q reports) or their annual reports on the investors relation page of their website.
Spreading information:
This is the boring part of the CCA. Now that you have your financial information ready, it is time to start “spreading” the information. “Spreading” the information is calculating key metrics and ratios for each company and organizing it in a spreadsheet.
Note: One important metric and value that should be used is: fully diluted shares outstanding. Shares outstanding is commonly used to derive market capitalization. Fully diluted shares outstanding is used by all investors to derive true Earnings Per Share (EPS). To calculate fully diluted shares outstanding, add current shares outstanding with amount of shares through convertible notes, preferred shares, and stock options. This will give the value of how many true shares exist in the marketplace.
Benchmarking and True Comparison:
Now this is the fun part of the analysis. Get your thinking hats on. After looking at each company, you must understand the whole story behind each number. Each multiple, each ratio, and each metric speaks a story. Understanding why it is low, or high comparatively will help determine its relevance to your target company. It is low due to declining sales or market share, did a sales contract expire, or did they invest in a new plant? This step is how you as an investor will create a valuation range that is more accurate and tighter.
Freddy’s:
Looking at our comparable companies, we recognize that Freddy’s has a size between a small and mid — sized company based on its Enterprise Value ratios. The lower end of their valuation multiples will be based on ClickWink, and the higher end will be based on snapfocus. One key thing to note, is that AntBlock was almost perfectly in the middle, but their core business of healthcare marketing was not aligned with Freddy’s. This led to the other two companies being the primary valuation boundaries.
Valuation:
This is the final step and will be used to help with the final investment decision. Looking at the bench-marked and relevant companies, use the key multiples to determine a valuation range based on the industry (some industries use EV/EBITDA, while others use P/E).
Freddy’s:
As an investor looking to have a minor stake in Freddy’s (not more than 1%), the key ratio that will help us is the P/E ratio. We are looking to minimize portfolio risk with returns not being to he primary goal. For this we re-arrange the P/E ratio to come with a price range. Looking at this chart developed from the price ranges, Freddy’s can be valued at its future estimated share price to determine whether it is a good investment or not. With our analysis, it can be concluded that investing in Freddy’s currently is not advisable. With a current share price of $33.50, the maximum upside is potential is not as high as the downside risk.
If the stock were to reach a price point of $30.90, it would be a good investment as the downside risk is limited.
That is the basic way to value companies. It is a very powerful tool and a staple in any industry role. This method allows an investor to understand a prospective company in comparison with other industry companies. It does have its limitations and no investor should solely rely on one tool for making a final decision; however it is a great way to understand the fundamentals of a company.
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Disclaimer: All companies in this article are fictitious and any resemblance to any real company is a coincidence. The author, Jai Betala, and investBETA are not soliciting any investment advice.
