When determining the value for a business, market multiples of comparable businesses that have been acquired or that trade publicly on markets are an important consideration. As a relative valuation based on valuation metrics of recent transactions or the ongoing investing public’s perception of value for similar businesses, they provide a simple and quantitative indication of value as perceived by market participants involved in real buying and selling of securities in similar companies. With a robust and carefully-selected set of comparable companies, whether they be publicly traded or privately held, a broad set of data points about the context in which a business operates can be distilled and applied to the business’ valuation. But keep in mind that comparable companies aren’t being compared to your company – instead they function to narrow the field of market indications to better suit your company.
Comparable companies are a key source of the information gathered and applied in the valuation process, but it can be frustrating to identify comparable companies that are truly comparable. When dealing with the challenge of identifying comparable companies, it is important to be cognizant of the way the details from these companies are used in the valuation.
When most startup founders think about benchmarking their company against other comparable companies, they do it with an eye toward market multiples. A company’s Market Multiples—often derived from Revenue, EBITDA, or ARR—provide a straightforward metric to use in calculating a market-indicated value for an enterprise.
In considering market multiples, be aware that every business is unique. It’s not always clear what strategic elements lie beneath the surface of a Revenue or an EBITDA multiple. An investor could be eyeing strategic synergies or looking to unlock cash flows by trimming slack in the operating budget. Market multiples, when a representative sample is available, can provide a powerful indication of the market’s willingness to transact with business of similar models and in similar industries. However, it’s wise to exercise caution when pointing to a specific transaction as the indication of an entire market.
As a metric, volatilities don’t necessarily tell a startup operator much because they’re uniquely aware of market fluctuations and what that means for their business. But from a valuation perspective this can be one of the most important data points in an analysis of the price of common stock. Market Volatilities influence both forward-looking calculations, like the Option Pricing Method, and calculations determining the discount applicable to individual shares (see “Everyone Loves a Discount“).
No individual company is the best proxy for market and industry volatility, and it isn’t necessary to have an exact match for the company’s market or business model to pin down an appropriate volatility. Furthermore, volatilities are based on data observed in public markets and the companies informing this metric are almost never a good proxy for a smaller startup company. What valuation analysts are aiming to do by considering comparable companies in evaluating the volatility of a startup company is take the temperature of the industry in which a company operates. For example, cryptocurrency companies are vastly more volatile than industry-specific software companies; by identifying a set of comparable companies, a valuation analyst is trying to determine roughly what volatility applies to the industry in which a business operates.
BETAS AND COST OF CAPITAL
Similar to market volatility, comparable companies can be helpful in supporting the cost of capital applied to a startup company. Beta, another measure of volatility, helps determine the risk inherent in a company’s operations. The Beta observed in public companies can be a helpful input in evaluating the rate at which future benefit streams should be discounted to present value.
The considerations valuation analysts apply in selected Betas is analogous to the considerations applied in selecting Market Volatilities, intending to gauge an order of magnitude rather than a precise input. The Beta selected, often by considering a broad range of public companies, provides an important input in the calculations done to estimate the cost of capital for a specific company. Both function as a filter on a broader industry to help tailor the analysis to a more indicative range of market inputs.
When a valuation analyst suggests a list of comparable companies, keep in mind they’re not trying to imply that your company is exactly comparable to all companies on the list. Rather, the companies considered are being used as a proxy for the sub-industry in which your company is operating. This is just as true when considering which market multiples are appropriate to apply in the context of your business as it is when considering inputs based on the volatilities of comparable companies to apply in calculations of option pricing, discounts and cost of capital.