One of the most commonly used valuation methodologies is the Market Approach (also called Relative Valuation), whereby a target company is valued by applying the median of the trading multiples of a set of peers. A target company’s peer group is selected based on companies with similar risk and growth profiles to that of the target company. The basic assumption underlying this approach is that similar companies are valued similarly.
Below we suggest several factors that could be considered when determining and optimal peer group:
1. Same or similar industry classification
This is the most commonly used approach and most important one as companies in similar industries typically operate within a similar competitive environment with similar regulatory, legal and market dynamics.
For relatively large companies in mature industries, the above is a fairly simple exercise. The difficulty arises when the target company operates in a niche or nascent industry. Almost by definition, companies included in the peer group, being large and listed, are often fairly well diversified in terms of their product and service offerings. Below we offer some ideas to assist in expanding the narrow definition of “industry”:
- Overlap in analyst coverage
Analysts often cover only one industry, thus if analysts include companies in their analysis that fall outside of the narrow initial definition of the industry, it can be assumed that those companies have very similar/complementary industries.
- Comparable company descriptions, Wikipedia pages, websites, sustainability report
Companies often refer to some of their own competitors in their publications. Especially for diversified companies, this could lead to some valuable insights.
- Overlap/co-occurrence in news coverage
If companies are mentioned in the same news article they often have similar traits and could be considered peers.
2. Comparable size
One of the biggest mistakes practitioners sometimes make is to target peer group companies that are similar in size to the target company being valued. While in theory this would produce the optimal result, the reality is that most private companies being valued are significantly smaller (in terms of sales, number of employees, profit, etc.) than most listed companies. The result is that micro-cap (<$50m market cap) listed peers are sought as they are the closest in size. Several challenges arise with this approach:
- Micro caps typically trade much less frequently than mid- or large caps causing distorted betas;
- Micro caps can often be closely held, having only a small percentage of shares as free float which can also distort betas;
- Micro caps could have volatile earnings, thus resulting in periods with negative earnings and thus not usable multiples; and
While the goal could be to target a peer group that is similar in size to the target company, quality data (in terms of multiples and betas) is more important and should thus be prioritized. Once the peer group has been finalized, the appropriate discount to be applied to the observed multiples can be determined based on various differences between the peer group and the target company, one of which being relative size (more on discounts below).
3. Same or similar country or region
The starting position is normally to look for peers in the same country as the target company. The rationale is simple – companies in the same country are exposed to identical regulatory and tax regimes. This can become challenging in countries where there aren’t that many listed companies in a specific sector. It is therefore widely accepted that the geographic focus could be expanded to include other countries. The geographic focus can be expanded systematically as follows:
- Neighboring countries (provided that there share similar economic traits)
- Regions (especially regions with developed trade agreements such as the EU)
4. Comparable operating metrics
As alluded to earlier, there has been some empirical evidence suggesting that using peers with comparable operating metrics is more valuable than simply focusing on industry classification. A balanced approach would be to expand the peer group to include a wider selection of adjacent industries and geographies and then to target companies with comparable operating metrics, particularly Revenue Growth, Return on Equity and Total Assets.
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