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What is Comparative Firms Approach of Valuation?
Under the comparative firms approach of valuation, companies are valued depending on groups formed with the key relationships of the companies. The groups of companies are formed with similar companies or similar transactions to determine the value of a firm. By deciding the group of company, the general trends are applied to each company of a group. Since the valuation is done by comparison, the approach is known as comparative firms approach.
A Simple Approach in Evaluating a Company
The comparative firms approach is based on the fact that similar companies should have the same value and should sell for similar prices.
It is an easier approach for managers and financial analysts because the valuation does not depend on complex calculations or formulas for deriving the value of the firm. It is therefore the most straightforward approach to evaluate a company's value.
Steps Involved in Comparative Firms Approach
There are three steps involved in the comparative firms approach of evaluating a company.
1. Identification of the Group
The first step in the comparative firms approach is to identify the group of companies depending on similar products, size, age, growth, sales, revenues and profitability trends. This step must be done as efficiently as possible because selecting a wrong group in which companies differ widely may lead to incorrect results in the evaluation.
The identification of the group of the company should not be tough because the data related to the aspects of a company are available for the firms that have a good status in the market.
2. Calculation of the Firm Value
In this step, the firm value is calculated as a ratio to EBIT, sales, FCFs, and market to book value of assets of a group of firms that have comparable entities. The attributes are usually derived after the first step of identification of similar firms.
Sales, EBIT, FCF and book value of assets are believed as value drivers in this step. This step is important because the comparison of companies is done to identify their values in this step.
3. Finding the Average Value
In this step, the values obtained in the second step are averaged after calculating the firm's value depending on sales, EBIT and FCFs. Finding the average of ratios are then applied to sales, EBIT, FCFs of the firm.
The ratios are taken as data because they represent the attributes of a company that may offer insight into the value of the firm. Usually, there is no significant difference in the value of the ratios of comparable firms. So, their values may also not differ widely enough.
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