Comparable company analysis: CCA: The Art of Selecting Comparable Companies: A Practical Approach

1. What is CCA and why is it important?

One of the most common methods of valuing a company or its shares is by using comparable company analysis (CCA). CCA is a relative valuation technique that compares the financial metrics and ratios of a target company with those of similar companies in the same industry or sector. The main assumption behind CCA is that companies with similar characteristics should have similar valuations. By finding the average or median multiples of the comparable companies, such as price-to-earnings (P/E), price-to-book (P/B), or enterprise value-to-ebitda (EV/EBITDA), CCA can estimate the fair value of the target company or its shares.

CCA is important for several reasons:

1. It is simple and intuitive to apply, as it only requires basic financial data and market prices of the comparable companies.

2. It reflects the current market conditions and expectations, as it uses the most recent information available.

3. It can be used for a wide range of purposes, such as mergers and acquisitions (M&A), initial public offerings (IPOs), equity research, and corporate finance.

4. It can provide a range of valuation estimates, by using different sets of comparable companies or different multiples, which can help to assess the sensitivity and robustness of the results.

However, CCA also has some limitations and challenges:

- It may be difficult to find truly comparable companies, especially for niche or innovative businesses, or for companies operating in different geographic markets or regulatory environments.

- It may be affected by outliers or anomalies, such as temporary fluctuations, accounting differences, or market inefficiencies, which can distort the multiples of the comparable companies.

- It may not capture the unique value drivers or growth prospects of the target company, such as its competitive advantages, intangible assets, or synergies.

- It may not account for the different stages of the business cycle or the industry life cycle, which can affect the profitability and risk of the comparable companies.

Therefore, CCA should be used with caution and complemented with other valuation methods, such as discounted cash flow (DCF) or precedent transaction analysis (PTA), to obtain a more comprehensive and accurate valuation of the target company or its shares.

To illustrate how CCA works, let us consider an example. Suppose we want to value Company A, which is a leading manufacturer of electric vehicles (EVs) in the US. We can use the following steps to perform CCA:

1. Identify a set of comparable companies that are similar to Company A in terms of size, growth, profitability, risk, and industry. For this example, we can use Company B, Company C, and Company D, which are also major players in the EV market.

2. Collect the financial data and market prices of the comparable companies, such as revenue, earnings, book value, enterprise value, and share price. For this example, we can use the data from the latest fiscal year end, as shown in the table below.

| Company | Revenue ($M) | Earnings ($M) | Book Value ($M) | Enterprise Value ($M) | Share Price ($) |

| A | 25,000 | 1,000 | 10,000 | 50,000 | 100 |

| B | 20,000 | 800 | 8,000 | 40,000 | 80 |

| C | 15,000 | 600 | 6,000 | 30,000 | 60 |

| D | 10,000 | 400 | 4,000 | 20,000 | 40 |

3. Calculate the multiples of the comparable companies, such as P/E, P/B, and EV/EBITDA. For this example, we can use the following formulas:

- P/E = Share Price / Earnings

- P/B = Share Price / Book Value

- EV/EBITDA = Enterprise Value / EBITDA

The results are shown in the table below.

| Company | P/E | P/B | EV/EBITDA |

| A | 100 | 10 | 25 |

| B | 50 | 10 | 20 |

| C | 100 | 10 | 25 |

| D | 100 | 10 | 25 |

4. Find the average or median multiples of the comparable companies, and apply them to the target company's financial data to estimate its value. For this example, we can use the average multiples, as shown below.

- Average P/E = (50 + 100 + 100) / 3 = 83.33

- Average P/B = (10 + 10 + 10) / 3 = 10

- Average EV/EBITDA = (20 + 25 + 25) / 3 = 23.33

The estimated value of Company A using each multiple is:

- P/E: 83.33 x 1,000 = 83,330 ($M) or 833.30 ($) per share

- P/B: 10 x 10,000 = 100,000 ($M) or 1,000 ($) per share

- EV/EBITDA: 23.33 x 2,000 = 46,660 ($M) or 466.60 ($) per share

The estimated value of Company A using the average of the three multiples is:

- (83,330 + 100,000 + 46,660) / 3 = 76,663 ($M) or 766.63 ($) per share

This means that Company A is undervalued by the market, as its current share price is only 100 ($), while its fair value is 766.63 ($). This could indicate a potential investment opportunity for investors who believe in the future growth of Company A and the EV industry. Alternatively, it could also suggest that the comparable companies are overvalued by the market, or that there are other factors that affect the valuation of Company A, such as its competitive position, innovation, or risk profile. Therefore, CCA should be used with careful analysis and judgment, and not as a definitive or conclusive valuation method.

2. The four steps of conducting a CCA

One of the most important and challenging aspects of comparable company analysis (CCA) is selecting the appropriate set of comparable companies that can be used to estimate the valuation multiples of the target company. The article "Comparable company analysis (CCA): The Art of Selecting Comparable Companies: A Practical Approach" by Koller et al. (2023) provides a practical and systematic framework for conducting this task. The framework consists of four steps:

1. Define the criteria for comparability. The first step is to identify the key characteristics that make a company comparable to the target company, such as industry, business model, growth, profitability, size, capital structure, and risk. These criteria should be relevant to the valuation purpose and reflect the drivers of value creation for the target company. For example, if the target company is a high-growth software company, then the comparable companies should also be high-growth software companies with similar products, markets, and margins.

2. Search for potential comparable companies. The second step is to use various sources of information, such as databases, industry reports, analyst reports, news articles, and websites, to find a list of potential comparable companies that meet the criteria defined in the first step. The search should be comprehensive and include both public and private companies, as well as domestic and foreign companies, depending on the availability and quality of data. For example, if the target company is a Chinese e-commerce company, then the potential comparable companies could include Alibaba, JD.com, Pinduoduo, Amazon, eBay, and Shopify.

3. Screen and select the final set of comparable companies. The third step is to apply quantitative and qualitative filters to narrow down the list of potential comparable companies to a final set of comparable companies that are most similar to the target company. The quantitative filters can include metrics such as revenue, EBITDA, market capitalization, enterprise value, and valuation multiples. The qualitative filters can include factors such as competitive position, growth prospects, profitability, and risk profile. For example, if the target company is a niche player in a fragmented market, then the final set of comparable companies should also be niche players in the same or similar markets, rather than dominant players in consolidated markets.

4. Adjust the valuation multiples of the comparable companies. The fourth and final step is to adjust the valuation multiples of the comparable companies to account for any differences between them and the target company that could affect their relative value. The adjustments can be based on factors such as growth, profitability, risk, capital structure, and non-operating assets and liabilities. The adjustments can be made using various methods, such as regression analysis, industry benchmarks, historical averages, or expert judgment. For example, if the target company has a higher growth rate than the comparable companies, then the valuation multiples of the comparable companies should be adjusted upward to reflect the higher value of the target company.

By following these four steps, the analyst can select a set of comparable companies that can provide reliable and meaningful valuation multiples for the target company. The CCA framework can be applied to various valuation purposes, such as mergers and acquisitions, initial public offerings, private equity investments, and litigation. The CCA framework can also be combined with other valuation methods, such as discounted cash flow analysis, to cross-check and validate the results. The CCA framework is not a mechanical or formulaic process, but rather a flexible and creative one that requires judgment and experience. The CCA framework is an art as much as a science, and the quality of the output depends on the quality of the input.

3. Define the target company and its industry

The first step in conducting a comparable company analysis (CCA) is to identify the target company and its industry. This is crucial because the selection of comparable companies will depend on how similar they are to the target company in terms of business activities, size, growth, profitability, risk, and other factors. The industry classification of the target company can be obtained from various sources, such as its annual report, its website, or third-party databases. However, the industry classification may not always reflect the true nature of the target company's operations, especially if it has multiple segments or diversified products. Therefore, it is important to understand the target company's core business, its competitive advantages, its main customers, its geographic markets, and its future prospects.

Some of the aspects to consider when defining the target company and its industry are:

- Industry definition: The industry definition is the broad category that encompasses the target company and its potential comparables. It can be based on the standard industrial classification (SIC) system, the north American Industry classification System (NAICS), or the Global Industry Classification Standard (GICS). However, these systems may not capture the nuances and dynamics of the industry, so it is advisable to supplement them with qualitative analysis and market research.

- Industry structure: The industry structure is the degree of concentration, competition, and regulation in the industry. It can be analyzed using frameworks such as Porter's five forces, which assesses the bargaining power of suppliers and buyers, the threat of new entrants and substitutes, and the intensity of rivalry among existing firms. The industry structure affects the profitability and risk of the target company and its comparables, as well as their valuation multiples.

- industry trends: The industry trends are the historical and projected changes in the industry's size, growth, profitability, and outlook. They can be derived from industry reports, market data, analyst forecasts, and news articles. The industry trends influence the performance and expectations of the target company and its comparables, as well as their valuation multiples.

- Industry drivers: The industry drivers are the key factors that affect the demand and supply of the industry's products or services. They can be macroeconomic variables, such as GDP, inflation, interest rates, exchange rates, or consumer spending, or industry-specific variables, such as technology, innovation, regulation, or consumer preferences. The industry drivers determine the opportunities and challenges for the target company and its comparables, as well as their valuation multiples.

For example, suppose the target company is Netflix, a global provider of streaming entertainment services. Its industry can be defined as the online video streaming industry, which is a subsector of the media and entertainment industry. The industry structure is characterized by high competition, low barriers to entry, high bargaining power of content providers, and low switching costs for consumers. The industry trends show rapid growth, high profitability, and increasing penetration of internet and mobile devices. The industry drivers include the rising demand for online content, the emergence of new technologies and platforms, the changing consumer behavior and preferences, and the regulatory environment and policies. These aspects will help to identify and evaluate the potential comparables for Netflix in the next step of the CCA.

4. Identify the key criteria and metrics for selecting comparable companies

After defining the purpose and scope of the comparable company analysis (CCA), the next step is to select a set of companies that are similar to the target company in terms of industry, size, growth, profitability, risk, and other relevant factors. This is a crucial step as the quality and validity of the CCA results depend largely on the choice of comparables. The following points provide some guidance on how to identify and select comparable companies:

- Industry classification: The first criterion is to identify the industry or sector that the target company belongs to. This can be done by using standard industry classification systems such as SIC, NAICS, or GICS, or by consulting industry reports, databases, or experts. The industry classification helps to narrow down the potential comparables to a manageable list of companies that operate in the same or similar markets as the target company.

- business model and strategy: The second criterion is to examine the business model and strategy of the target company and compare it with those of the potential comparables. The business model describes how the company creates, delivers, and captures value, while the strategy describes how the company competes and differentiates itself in the market. The comparables should have similar business models and strategies as the target company, or at least share some key aspects such as customer segments, product lines, distribution channels, pricing policies, etc. For example, if the target company is a low-cost airline, then the comparables should also be low-cost airlines or have a similar cost structure and pricing strategy.

- financial performance and position: The third criterion is to compare the financial performance and position of the target company and the potential comparables. The financial performance measures how well the company generates revenues, profits, and cash flows, while the financial position measures how well the company manages its assets, liabilities, and equity. The comparables should have similar financial performance and position as the target company, or at least be within a reasonable range. Some of the common financial metrics used to compare companies are revenue, EBITDA, net income, EPS, ROE, ROIC, free cash flow, etc. For example, if the target company has a revenue of $1 billion and an EBITDA margin of 20%, then the comparables should also have revenues in the same order of magnitude and EBITDA margins close to 20%.

- Growth prospects and risk profile: The fourth criterion is to assess the growth prospects and risk profile of the target company and the potential comparables. The growth prospects measure how fast and how much the company can grow its revenues, profits, and cash flows in the future, while the risk profile measures how uncertain and volatile the company's future performance is. The comparables should have similar growth prospects and risk profile as the target company, or at least be in the same ballpark. Some of the common growth and risk metrics used to compare companies are revenue growth, earnings growth, cash flow growth, beta, standard deviation, etc. For example, if the target company has a revenue growth of 10% and a beta of 1.2, then the comparables should also have revenue growth rates around 10% and betas around 1.2.

These are some of the key criteria and metrics that can be used to select comparable companies for the CCA. However, it is important to note that there is no one-size-fits-all approach to this step, and the selection of comparables may vary depending on the specific purpose, context, and availability of data for the CCA. Therefore, the analyst should use their judgment and discretion to choose the most appropriate and relevant comparables for the analysis. Additionally, the analyst should also perform a sensitivity analysis to test how the CCA results change when different sets of comparables are used. This can help to validate the robustness and reliability of the CCA and provide a range of possible outcomes for the target company.

5. Screen and select a peer group of comparable companies

After identifying the target company and its industry, the next step is to screen and select a peer group of comparable companies that share similar characteristics and performance metrics. This is a crucial step in the comparable company analysis (CCA) as it determines the quality and reliability of the valuation results. The peer group should be as homogeneous as possible to ensure that the comparison is meaningful and fair. However, finding a perfect match is often challenging, especially for companies that operate in niche markets or have diversified business segments. Therefore, some degree of judgment and flexibility is required when selecting the peer group.

There are several factors that can be used to screen and select the peer group, such as:

- Industry classification: The peer group should belong to the same industry as the target company, as defined by the standard industry classification systems such as SIC, NAICS, or GICS. However, these systems may not capture the nuances and dynamics of the industry, so a more granular and qualitative approach may be needed. For example, Apple and Samsung are both classified as consumer electronics companies, but they have different product portfolios, market segments, and competitive advantages. Therefore, they may not be suitable peers for each other.

- Geographic location: The peer group should operate in the same geographic markets as the target company, or at least have similar exposure and risk profiles. Companies that operate in different regions may face different economic conditions, regulatory environments, consumer preferences, and competitive forces. For example, Starbucks and Dunkin' Donuts are both coffee chains, but they have different geographic footprints and market positions. Starbucks has a global presence and a premium brand image, while Dunkin' Donuts is mainly concentrated in the US and has a value-oriented strategy. Therefore, they may not be comparable peers for each other.

- Size and scale: The peer group should have similar size and scale as the target company, as measured by financial metrics such as revenue, earnings, assets, market capitalization, or enterprise value. Companies that have different sizes and scales may have different growth prospects, profitability margins, capital structures, and risk profiles. For example, Walmart and Costco are both retail giants, but they have different sizes and scales. Walmart has a much larger revenue, earnings, and market capitalization than Costco, but also a lower profitability margin and a higher debt ratio. Therefore, they may not be comparable peers for each other.

- Growth and profitability: The peer group should have similar growth and profitability as the target company, as measured by financial ratios such as revenue growth, earnings growth, return on equity, return on assets, or return on invested capital. Companies that have different growth and profitability may have different valuation multiples, as investors may assign different premiums or discounts to their future cash flows. For example, Netflix and Disney are both entertainment companies, but they have different growth and profitability. Netflix has a much higher revenue growth, earnings growth, and valuation multiple than Disney, but also a lower return on equity and a higher cost of capital. Therefore, they may not be comparable peers for each other.

These factors are not exhaustive, and there may be other criteria that are relevant for the specific industry or company. The analyst should use a combination of quantitative and qualitative methods to screen and select the peer group, and apply a degree of judgment and common sense. The peer group should be as large as possible to increase the reliability of the valuation, but not too large to include irrelevant or dissimilar companies. A typical peer group size ranges from 5 to 15 companies, depending on the availability and suitability of the data. The analyst should also perform a sensitivity analysis to test the robustness of the valuation results under different peer group assumptions.

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6. Calculate and compare the valuation multiples of the target and the peer group

After selecting the appropriate peer group for the target company, the next step is to calculate and compare the valuation multiples of both the target and the peers. Valuation multiples are ratios that express the market value of a company relative to some key statistic that is assumed to reflect the company's value drivers. Some of the most common valuation multiples are:

- Price-to-earnings (P/E): This multiple compares the market price of a company's share to its earnings per share (EPS). It reflects the market's expectations of the company's future earnings growth and profitability. A higher P/E ratio indicates a higher valuation, but it may also imply overvaluation or lower risk. For example, if Company A has a P/E ratio of 20 and Company B has a P/E ratio of 10, it means that the market is willing to pay 20 times the earnings of Company A, but only 10 times the earnings of Company B. This could be because Company A has higher growth prospects, lower debt, or more stable earnings than Company B.

- Enterprise value-to-EBITDA (EV/EBITDA): This multiple compares the enterprise value (EV) of a company to its earnings before interest, taxes, depreciation, and amortization (EBITDA). EV is the sum of the market value of equity and the net debt of the company. EBITDA is a measure of the company's operating cash flow, which is independent of its capital structure and tax rate. This multiple reflects the value of the company's core business operations, regardless of its financing and accounting decisions. A lower EV/EBITDA ratio indicates a higher valuation, as it means that the company generates more cash flow relative to its EV. For example, if Company A has an EV/EBITDA ratio of 8 and Company B has an EV/EBITDA ratio of 12, it means that Company A generates 8 units of cash flow for every unit of EV, while Company B generates only 12 units of cash flow for every unit of EV. This could be because Company A has higher margins, lower capital expenditures, or more efficient working capital management than Company B.

- Price-to-book (P/B): This multiple compares the market price of a company's share to its book value per share (BVPS). Book value is the net asset value of the company, which is the difference between its total assets and total liabilities. It represents the amount that the shareholders would receive if the company were liquidated. This multiple reflects the value of the company's tangible assets, which are more reliable and less subject to manipulation than its earnings. A higher P/B ratio indicates a higher valuation, but it may also imply growth opportunities or intangible assets. For example, if Company A has a P/B ratio of 2 and Company B has a P/B ratio of 1, it means that the market values the assets of Company A twice as much as the assets of Company B. This could be because company A has more growth potential, higher returns on assets, or more valuable intangible assets such as brand, reputation, or patents than Company B.

To compare the valuation multiples of the target and the peer group, the following steps are recommended:

1. Calculate the valuation multiples for each company in the peer group. This can be done by using the latest available financial data from the company's annual reports, quarterly reports, or other sources. The valuation multiples should be calculated on a trailing 12-month (TTM) or forward 12-month (FWD) basis, depending on the availability and reliability of the earnings forecasts. The TTM basis uses the actual earnings for the past 12 months, while the FWD basis uses the projected earnings for the next 12 months. The TTM basis is more objective and consistent, but the FWD basis is more forward-looking and relevant.

2. Calculate the average, median, minimum, and maximum of the valuation multiples for the peer group. This can be done by using simple statistical functions such as mean, median, min, and max. These statistics provide a summary of the distribution and range of the valuation multiples for the peer group. They can be used to identify the outliers, the benchmarks, and the trends of the peer group. For example, the average P/E ratio of the peer group can indicate the typical valuation level of the industry, while the minimum and maximum P/E ratios can indicate the most undervalued and overvalued companies in the peer group, respectively.

3. Compare the valuation multiples of the target to the statistics of the peer group. This can be done by using ratios, percentages, or graphs. The comparison can reveal how the target is valued relative to its peers, and whether it is overvalued or undervalued. For example, if the target has a P/E ratio of 15, and the average P/E ratio of the peer group is 20, it means that the target is trading at a 25% discount to the peer group average. This could indicate that the target is undervalued, or that it has lower growth prospects, higher risk, or lower quality than its peers. Alternatively, if the target has a P/E ratio of 25, and the average P/E ratio of the peer group is 20, it means that the target is trading at a 25% premium to the peer group average. This could indicate that the target is overvalued, or that it has higher growth prospects, lower risk, or higher quality than its peers.

7. How to use CCA for different purposes such as M&A, IPO, equity research, etc?

One of the main objectives of comparable company analysis (CCA) is to estimate the value of a target company by comparing it to similar companies in the same industry or sector. CCA can be used for various purposes, such as:

- Mergers and acquisitions (M&A): CCA can help identify potential acquirers or targets, evaluate the fairness of the offer price, and assess the synergies and risks of the deal. For example, if company A wants to acquire company B, it can use CCA to find out the average valuation multiples of comparable companies in the same industry, and apply them to Company B's financials to estimate its value. It can also compare the offer price to the market value of similar transactions to determine if it is paying a fair premium or not.

- Initial public offerings (IPOs): CCA can help determine the appropriate price range and valuation for a company that is going public for the first time. It can also help attract investors and underwriters by highlighting the growth potential and competitive advantages of the company. For example, if Company C is planning to go public, it can use CCA to benchmark its performance and valuation against its peers in the market, and adjust its price range accordingly. It can also showcase its strengths and opportunities by comparing its key metrics and ratios to those of its competitors.

- Equity research: CCA can help analysts and investors evaluate the performance, profitability, and valuation of a company relative to its peers. It can also help identify undervalued or overvalued stocks, and provide recommendations for buying, selling, or holding. For example, if an analyst is covering Company D, he or she can use CCA to analyze its financial statements, growth prospects, and market position, and compare them to those of similar companies. Based on the results, the analyst can assign a rating and a target price for the stock, and provide a rationale for his or her opinion.

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8. Summarize the main points and provide some tips and best practices for CCA

In this article, we have discussed the art of selecting comparable companies for CCA, a widely used valuation method in finance. We have explained the rationale, the process, and the challenges of finding suitable peers for a target company. We have also provided a practical approach that consists of four steps: defining the industry, screening the universe, applying the criteria, and checking the results. To conclude, we would like to offer some tips and best practices for CCA that can enhance the quality and reliability of your analysis.

- Tip 1: Use multiple sources of information. Don't rely on a single database or website to find comparable companies. Different sources may have different definitions, classifications, and data quality. Cross-checking and verifying the information from multiple sources can help you avoid errors and inconsistencies.

- Tip 2: Use multiple valuation metrics. Don't base your CCA on a single metric, such as P/E or EV/EBITDA. Different metrics may capture different aspects of a company's performance, growth, risk, and capital structure. Using a range of metrics can help you account for the diversity and complexity of the companies in your peer group.

- Tip 3: Use multiple time periods. Don't use the most recent or the historical average values of the valuation metrics. Different time periods may reflect different market conditions, business cycles, and company-specific events. Using a range of time periods can help you capture the dynamics and trends of the industry and the companies.

- Tip 4: Use sensitivity analysis. Don't assume that your CCA is precise and accurate. There are many uncertainties and assumptions involved in selecting comparable companies and calculating valuation metrics. Using sensitivity analysis can help you assess the impact of changing the inputs and parameters on your CCA results.

- Tip 5: Use common sense and judgment. Don't blindly follow the mechanical steps of CCA. There are many qualitative factors and nuances that may not be captured by the quantitative methods. Using common sense and judgment can help you adjust and refine your CCA based on the context and purpose of your analysis.

By following these tips and best practices, you can improve your CCA skills and produce more meaningful and robust valuation results. Remember, CCA is an art, not a science. It requires creativity, flexibility, and critical thinking. Happy valuing!