Now that we understand market multiples and Enterprise Value, the next crucial skill is finding the right companies to compare.
Without proper comparable companies, even perfectly calculated ratios become meaningless. Think of it like comparing your house value - you need similar homes in similar neighborhoods.
Engagement Message
What would happen if you compared a tech startup to a mature bank using P/E ratios?
The foundation of good comparables is industry similarity. Companies should compete in the same market, face similar regulations, and have comparable profit margins.
A pharmaceutical company and a retail chain might both be profitable, but their business fundamentals are completely different.
Engagement Message
Why would comparing across different industries give misleading results?
Size matters enormously in comparable analysis. Large companies often have advantages like economies of scale, better financing terms, and market power that smaller firms lack.
Comparing Microsoft to a small software startup using the same multiples would be like comparing a mansion to a studio apartment.
Engagement Message
What specific advantages might a $100B company have over a $1B company in the same industry?
Even within the same industry, business models must align. Consider two restaurant companies - one owns its locations, another franchises everything.
Their cost structures, capital requirements, and risk profiles are fundamentally different despite both selling food.
Engagement Message
Can you think of another industry where business models vary significantly within the same sector?
Geographic location creates another layer of complexity. Companies in different countries face varying tax rates, regulations, growth rates, and currency risks.
A Chinese tech company and a US tech company might look similar operationally but trade at different multiples for good reasons.
Engagement Message
Why might investors pay different multiples for identical businesses in different countries?
What happens when you can't find enough good comparables? This is common with unique business models or niche industries.
You have three options: expand your search criteria carefully, use broader industry averages, or rely more heavily on other valuation methods like cash flow analysis.
Engagement Message
Which compromise would you make first: industry match or size match?
Remember: three perfect comparables beat ten mediocre ones. Quality trumps quantity every time in valuation analysis.
It's better to acknowledge limited comparability and use multiple valuation approaches than to force poor comparisons and reach unreliable conclusions.
Engagement Message
On a scale of 1-5, how confident would you be investing based on weak comparables?
Type
Sort Into Boxes
Practice Question
You're valuing TechFlow, a mid-size US software company that sells business software to other companies. Sort these potential comparables into good or poor matches.
Labels
- First Box Label: Good Comparable
- Second Box Label: Poor Comparable
First Box Items
- BusinessSoft (sells business software)
- DataTech Inc (sells enterprise software)
- WorkFlow Systems (sells productivity software)
Second Box Items
- Netflix (sells entertainment streaming)
- Toyota (makes cars)
- Local Pizza Chain (sells food)
