Comparable Companies and Precedent Transactions

Why this matters

Relative and Historical Valuation introduced the idea of judging a multiple against similar companies. Professionals do this constantly, and the result often gets quoted as if it were a fact: "peers trade at 13 times". Behind that sentence are several choices that can move the answer by a third. This lesson shows how the calculation is done and where the choices are.

Comparable companies, step by step

1. Choose the peer group. Look for companies with a similar business, similar growth and margins, and similar risk. A handful of good matches is better than a long list of poor ones.
2. Choose the multiple. It has to suit the industry, and the top and bottom must match. A measure of profit before interest, such as operating income, goes with enterprise value. A measure after interest, such as net income, goes with the value of the shares. Market Cap vs. Enterprise Value explained why.
3. Make the numbers comparable. Remove one-time items, treat leases and stock-based compensation the same way for every company, and use the same period for all of them.
4. Find the typical multiple. Use the median, which a single extreme company can't distort.
5. Apply it to the company being valued, and convert to a value per share.

Peer	Enterprise value ÷ operating income	Revenue growth
Company A	10.5	5%
Company B	12.0	8%
Company C	13.0	10%
Company D	15.5	14%
Company E	24.0	30%
Median	13.0	10%
Average	15.0	13%

STU Corp's operating income is $80 million. At the median of 13 times, its enterprise value would be $1,040 million. It has $90 million of debt and $60 million of cash, so net debt is $30 million and the shares would be worth $1,010 million, or $50.50 each on 20 million shares. That's almost exactly its $50 price.

Where the judgment is

That answer looks precise. Three reasonable changes show how much it depends on choices.

Choice	Multiple applied	Value per share
Median of all five peers	13.0	$50.50
Average of all five, pulled up by Company E	15.0	$58.50
Company D only, the peer growing at STU Corp's 14%	15.5	$60.50
Median without the two fastest growers	12.0	$46.50

The range runs from $46.50 to $60.50 with no change in STU Corp or in the peers' prices. Anyone who wants a particular answer can find a defensible way to get it. When you read someone else's comparison, look first at who was included and who was left out.

The table also shows why the peers' multiples differ. Faster growth goes with a higher multiple, all the way down the list. A company growing at 14% compared with peers growing at 10% deserves more than the median, which is the argument for the $60.50 figure. Before applying a peer multiple, compare the things that drive it:

• Growth. Faster expected growth justifies a higher multiple.
• Profitability and returns. A company earning more on the money invested in it is worth more per dollar of profit, as Is It Profitable? showed with return on invested capital.
• Risk. More debt, a concentrated customer base, or a more cyclical business justifies less.
• Accounting. The adjustments from Quality of Earnings apply to every peer, not only the company being valued. A peer whose profit includes a one-time gain will show a multiple that's too low.

The rest of this lesson is for members

Still to come in this lesson: Precedent transactions, What neither method can do, the key takeaways, and 2 quiz questions with explanations.

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