Optimal equity valuation using multiples: The number of comparable firms

• Published date: 01 September 2023
• Author: Ian Cooper,Neophytos Lambertides
• Date: 01 September 2023
• DOI: http://doi.org/10.1111/eufm.12405

DOI: 10.1111/eufm.12405

ORIGINAL ARTICLE

Optimal equity valuation using multiples: The

number of comparable firms

Ian Cooper

1

|Neophytos Lambertides

2

1

London Business School, Sussex Place,

Regent's Park, London, UK

2

Department of Finance, Accounting and

Management Science, Cyprus University

of Technology, Limassol, Cyprus

Correspondence

Neophytos Lambertides, Department of

Finance, Accounting and Management

Science, Cyprus University of

Technology, 115 Spyrou Araouzou Street,

3036 Limassol, Cyprus.

Email: n.lambertides@cut.ac.cy

Abstract

We examine how the accuracy of a multiples‐based

valuation changes as the number of comparable firms

used to estimate the valuation multiple increases. Our

research is motivated by a contrast between the

approach followed by practitioners, who typically

use a small number of closely comparable firms, and

the academic literature which often uses all firms in an

industry. Using a simple selection rule based on growth

rates, we find that using 10 closely comparable firms is

as accurate on average as using the entire cross‐section

of firms in an industry. The loss of accuracy from using

five comparable firms rather than 10 firms or the entire

industry is not great.

KEYWORDS

equity valuation, multiples valuation, valuation

JEL CLASSIFICATION

G11, G24, D81

Eur Financ Manag. 2023;29:1025–1053. wileyonlinelibrary.com/journal/eufm

|

1025

EUROPEAN

FINANCIAL MANAGEMENT

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial‐NoDerivs License, which permits

use and distribution in any medium, provided the original work is properly cited, the use is non‐commercial and no modifications or

adaptations are made.

© 2022 The Authors. European Financial Management published by John Wiley & Sons Ltd.

We are grateful to an anonymous referee and the editor for helpful comments and suggestions. We would also like to

thank Leonardo Cordeiro for his valuable research assistance. All errors remain our responsibility.

1|INTRODUCTION

In this study we examine how the accuracy of a multiples‐based valuation changes when the

number of comparable firms used to estimate the valuation multiple increases. Our research is

motivated by a contrast between the approach commonly followed by practitioners and that

generally used in the academic literature. In multiples‐based valuation, practitioners generally

use a small number of closely comparable firms to estimate the multiple.

1

The academic

literature generally uses all firms in an industry as the comparable group. We seek to

investigate which of these is optimal. We also examine a number of related issues, such as the

method of selecting the small sample, and the variation of accuracy across industries and

over time.

Using an entire industry as the comparable group has two main advantages. It does not

require the choice of a procedure to select a smaller sample and it uses all the information

contained in the multiples of the firms in the industry. However, we show that the use of more

information is not necessarily better. If multiples that contain little incremental information

about a valuation are given weight at the expense of those that contain the most information,

increasing the number of comparable firms can decrease accuracy.

Using a smaller sample has the advantage that it uses only the most relevant information.

However, this requires a procedure to select the comparable firms whose share prices are likely

to contain the most information about the value of the target firm being valued. A small sample

also allows the valuer to exercise judgement about which are the most comparable firms and

what weights their multiples should be given. The disadvantage of a small sample is that it may

ignore the information contained in the multiples of those firms not contained in the sample.

We show theoretically that for a larger sample to improve a valuation the relative weights

given to the multiples of comparable firms must satisfy a particular criterion. For any given

valuation procedure, we show that it is not possible to guarantee that this condition will be

fulfilled. Therefore, it is not clear theoretically whether a large or small sample will give a more

accurate valuation. The issue is, essentially, an empirical one.

To carry out our empirical test we use the method of valuation using multiples that has

been found to be optimal in the academic literature. This uses forward earnings as the value

driver and the harmonic mean to average the multiples of comparable firms. We vary the

number of comparable firms used in the valuation, and measure the accuracy of the resulting

value estimate by comparing it with the market price. We select comparable firms based on the

absolute difference between the growth rate of the comparable firm and the growth rate of the

target firm.

We measure accuracy by the bias, mean absolute deviation (MAD), and mean squared

error (MSE) of the value estimates. By all these criteria, we find that using about 10 closely

comparable firms is as accurate as using the entire cross‐section of firms in an industry. Using

five comparable firms is slightly less accurate. However, the loss of accuracy from using five

comparable firms rather than 10 firms or the entire industry is not great.

We also examine whether the relative accuracy of a small sample relative to a large sample

varies in a systematic way between industries or over time. We find that industry characteristics

help only marginally in explaining the relative accuracy of large and small numbers of

comparables. What is far more important is the closeness of the growth rates of the comparable

1

Examination of brokers' reports shows that a typical sample size is 4–6 firms.

1026

|

EUROPEAN

FINANCIAL MANAGEMENT

COOPER AND LAMBERTIDES