Selection of Comparison Firms

The single biggest problem with comparables may be the selection of appropriately comparable firms. Say, you own a little soda producer, the Your Beverage Corporation (YBC), with earnings of $10 million. You want to select public firms to use as your comparables from the universe of firms. Usually, this means publicly traded companies. So, which of the 10,000 or so publicly traded companies are most comparable to your firm (or project)? Are firms more similar if they are similar in assets, similar in their business products and services, similar in their geographical coverage, similar in their age, similar in their size and scale, etc.? Do they have to be similar in all respects? If so, chances are that not a single of the 10,000 firms will qualify!
Let us assume that after extensive research and much agonizing, you have identified the (same) three companies: KO, PEP, and CSG. Which one is most similar? You know that depending on which firm you select, your valuation could be $250 million (if Cadbury Schweppes, unlevered, was most similar), $410 million (if PepsiCo was most similar), or $500 million (if Coca Cola was most similar). Which shall it be?
Selecting comparables depends both on the judgment and on the motives of the analyst. In the YBC case, one analyst may consider all three firms (KO, PEP, and CSG) to be similar, but CSG to be most similar because it is the smallest comparison firm. She may determine a good P/E ratio would be 30. Another analyst might consider Coca Cola and Pepsi-Co to be better comparables, because they tend to serve the same market as YBC. He may determine a good P/E ratio would be 40. The owner of YBC may want to sell out and try to find a buyer willing to pay as much as possible, so she might claim Coca Cola to be the only true comparable, leading to a P/E ratio of 50. The potential buyer of YBC may instead claim Cadbury Schweppes to be the only comparable, and in fact attribute an extra discount to CSG: after all, YBC is a lot smaller than CSG, and the buyer may feel that YBC deserves only a P/E ratio of 10. There is no definitive right or wrong choice.
Another choice may be not to select either the P/E ratio of 10 or the P/E ratio of 45, but to “split the difference.” A reasonable P/E ratio that is better than either 10 or 45 may be 30. This might mean valuations of around $300 to $400 million. Unfortunately, though this may be the best solution, it is not a good solution.