Have you considered whether the companies adopted as ‘comparable to one another’ by Analysts are similar enough in all respects to make share price comparisons between them meaningful?

Comparative analysis utilizes key operating ratios and multiples of what are thought to be similar businesses or so-called ‘peer group companies’. To qualify as comparables, companies must be in the same business, undertake only the same business functions, and have the same risk profiles. When selecting comparable companies, consideration should be given to factors including:

• strategic focus;

• products or services offered and geographic coverage, market characteristics, and market share; and,

• size, financial structure, net tangible assets, operating capacity, revenue components and percentage mix, cost structure, profitability and free cash flow.

Comparative analysis is often adopted as a primary valuation methodology by Securities Analysts. However, typically corporate acquirers don’t in our experience focus on this to the same degree. Rather, if corporate acquirers use comparative analysis, we have observed they do so to broadly test value conclusions determined pursuant to a discounted cash flow or other ‘return on investment’ methodology.

None of this is to say that comparisons between companies in the same industry that exhibit similar characteristics should not be compared in a public market context by balance sheet and financial ratios, stock market metrics, and so on. Indeed, they should be so compared in these ways – but largely to determine which companies appear to be more attractive than their contemporaries from an investment point of view. Once that is determined the companies deemed most attractive then can be analyzed in depth – the comparisons with their contemporary companies being only one factor to be weighted in any decision as to whether or not to invest.

Where companies considered appropriate for comparability purposes have been identified, adjustments to the stated financial results of those businesses may be necessary to enhance comparability. Required adjustments may include differences in accounting policies, financial structure (i.e. mix of debt and equity), income tax rates, and forecasts. In most cases, the detailed data required to make the appropriate adjustments is not available. Where the differences could be significant, this militates against meaningful comparability.

The views expressed in this Post are those of the author. They are offered to readers for information and general guidance only. They are neither intended to, nor should be taken to, constitute economic or investment advice. See Legal Disclaimer.

Email this Post to a Friend.

Trackback URI | Comments RSS