How to Select Comparable Companies by Business Model, Not Just Industry
Relative valuation depends on the peer group. Reduce selection bias by aligning business models, growth, risk, and accounting, and by distinguishing averages from medians.
Select comparable companies by checking similarities in revenue structure, profitability, growth stage, and risk, rather than relying only on industry labels. Where conditions still differ, not every multiple difference can be attributed to undervaluation or overvaluation. Recording inclusion and exclusion criteria first reduces the risk of changing the peer group to obtain a desired conclusion.
Compare earnings models alongside industry classifications
The same software industry can include subscription services, labor-intensive implementation businesses, and advertising platforms. Customers pay for different reasons, with different recurrence, pricing power, and retention costs, making a single revenue multiple difficult to apply. First record core product exposure, customer concentration, regional demand, and asset intensity. If no pure comparable exists, look for companies resembling a particular segment or state the comparison’s limitations. A company in another industry may provide a useful reference if it generates cash similarly, but explain the reasoning for including it.
Reconcile differences in periods and accounting
Different fiscal year-ends can mean figures labeled annual earnings cover different economic conditions. Realign them to the latest four quarters or a common forecast period, and standardize exchange rates and units. Apply consistent adjustment principles to stock-based compensation, research and development, leases, and one-time gains and losses. Excluding loss-making companies’ PERs can bias the sample toward surviving profitable companies, so record how many companies were excluded and why. If data cannot be aligned, stating why a comparison is not possible is more accurate than forcing a single average.
Examine the distribution and causes of differences, rather than one average
A few very high multiples can substantially raise the mean, so examine the median and range as well. The median is not necessarily the appropriate multiple either. If the subject company has lower returns or less durable growth than the peer group, applying the same multiple becomes harder to justify. When using discounts or premiums, review which risks or competitive strengths are already reflected in earnings and multiples rather than attaching a customary percentage. Checking whether removing one peer changes the conclusion substantially reveals sensitivity to sample selection.
Worked example
Hypothetical example: Four reviewed companies have PERs of 8x, 10x, 12x, and 50x for the same period. The simple mean is 20x and the median is 11x. Applying the 20x mean to the subject company without checking whether the 50x figure reflects temporarily depressed earnings or strong long-term growth can distort the conclusion. The mean excluding that company is 10x, but the exclusion itself also requires an economic rationale.
What to check
- Are customers, business models, and asset intensity similar across the peer group?
- Have you aligned earnings periods and accounting adjustment principles?
- Have you documented excluded companies and the reasons for exclusion?
- Have you checked the mean, median, and the effect of changes in the sample?
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.