Comparable Valuation Method: Benchmarking Your Startup Against Winners

The comparable valuation method can be a game-changer for early-stage, pre-revenue startups. Such companies don’t have any real metrics to prove their worth to investors and must rely on projections.

Investors need verifiable numbers to estimate their potential for growth and profitability, which they lack. A practical solution is to focus on similar businesses operating within the same sector. This solution references updated market data that investors can leverage for comparisons.

You can also use the comparable valuation method for startups at later growth stages. Established companies that are close to achieving a positive Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).

This is a highly adaptable technique that provides a comprehensive overview of the company’s value. Reading through this article will give you an overview of selecting the right comparative benchmarks for your company. You’ll also learn about how to use this method to get capital for your company.

Understanding the Comparable Valuation Method

The comparable valuation method, or comp-based valuation as it is also called, is similar to how real estate agents value houses. They determine prices based on comparable homes in the same location with similar amenities and facilities.

Taking a page out of the real estate playbook, investors compare the company seeking capital to similar startups. These startups have recently attracted venture capital (VC) funding or have been acquired. Investors use benchmarks such as location, industry, and potential market size and reach.

Many investors consider the comparables method more reliable than financials and spreadsheets for seed and Series A funding. Without comparing similar companies, they are unable to draw credible conclusions about the startup’s potential.

Startups in their nascent stages have no historical trends and numbers to demonstrate. But, investors are likely to accept projected valuations of, say, $100M to $150M in the next 5 years. That is, if similar companies have had such results. This market-based approach is much more reliable for investors.

The comparables method is also referred to as “public market multiples,” “equity comps,” “peer group analysis,” and “trading multiples.” You’ll select comparable companies and analyse their valuation metrics, such as Enterprise Value to Revenue (EV/Revenue) and Price-to-Earnings (P/E) ratio.

Next, you’ll apply these numbers to your startup’s projected financial metrics and calculate its valuation. This technique helps you arrive at a realistic starting point for valuing the company when approaching investors for funding.

How the Comparable Valuation Method Works

The comp-based valuation approach helps determine whether the startup is undervalued, overvalued, or appropriately valued. You’ll use this technique along with other valuation methods, such as the asset-based approach and discounted cash flow (DCF).

You’ll also factor in the results from the precedence approach and book value approach. Utilizing a combination of methods ensures that you arrive at an accurate valuation. However, identifying truly comparable companies’ metrics is crucial for a precise analysis.

For example, you consider competing companies operating on a similar business model and at a comparable growth stage, within the same sector. If your company has a lower valuation despite similar performance, it may be undervalued.

Accordingly, investors might back the company by purchasing equity, anticipating that its stock price will appreciate. They expect that the startup is poised for accelerated growth. On the other hand, if the company has a higher valuation and appears overvalued, investors may choose to sell short.

In other words, they may “short” the stock or position their portfolio to benefit. That is, if the startup’s share price drops in the future.

How Other Equity Valuation Methods Work

Let’s take a quick look at the other valuation methods you should factor in, along with the comparable valuation method:

• An asset-based approach determines a company’s valuation by assigning fair market value to its net assets. This method applies to companies that are currently operating and calculates their assets minus their liabilities. It works for those with significant physical assets, such as inventory, real estate, equipment, and intellectual property (IP).
• The Discounted Cash Flow (DCF) method is suitable for companies with robust data to make accurate predictions about their future earnings. You’ll determine their equity value by using the net present value to forecast their cash projections.
• The precedence approach calculates a company’s equity value based on the historical prices at which recent M&A deals closed. These deals should be within the same industry and between similar companies. You can also consider the valuations calculated for the participating companies.
• If your startup was recently acquired, you can use the book-value approach to determine its valuation. However, this method only works if the company has experienced minimal growth.

Calculating Equity Using the Comparable Valuation Method

When calculating a company’s comp-based valuation, you’ll factor in financial ratios or EV multiples. EV or economic value multiples enable you to compare different companies while disregarding general market conditions and their respective sizes.

You’ll identify peers within the commercial landscape, market leaders, clients and customers, vendors or suppliers, and other entities. The underlying criterion is that their business models and operational strategies should be similar to those of your company.

However, the success and growth of companies depend entirely on both micro and macro factors in the business landscape. This is why you cannot rely entirely on the comparable valuation method, but must also leverage other calculation techniques.

Combining different methods enables you to analyze the company using comprehensive information sourced from various data sets. These values help you create a narrative when pitching to investors.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

You’ll compile metrics like:

• Projected or estimated revenues or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
• Comparables’ EBITDA multiple is the ratio between a company’s value and its annual EBITDA
• Comparables’ revenue multiple or enterprise value (EV)/revenue is the ratio between a company’s value and its annual revenue. This ratio is applicable when the company’s profits are low or negative, and it derives earnings from multiple sources.
• Enterprise-value-to-sales (EV/S) compares a company’s total value (enterprise value) to its annual sales revenue.
• Enterprise multiple reflects a company’s total value. You’ll factor in the company’s market capitalization (the total value of its outstanding shares) and add outstanding debt. Next, you’ll deduct cash and cash equivalents to arrive at its actual economic value.
• The price-to-earnings (P/E) ratio compares the company’s share price and its earnings per share. This value is helpful for mature startups that demonstrate significant profits.
• The price-to-book (P/B) ratio calculates the company’s closing share price divided by its book value per share.
• Price-to-free-cash-flow (P/FCF) ratio compares a company’s stock price to its free cash flow per share.

Let’s try an example. You operate in the SaaS sector, and similar companies trade at 15x annual revenue. Accordingly, if your startup has yearly revenue of $5M, you can assume its valuation is $75M. Here, $5 x 15 = $75M using the comparable valuation method.

Selecting the Right Comparable Companies for Valuation

The cornerstone of getting accurate results is selecting the optimal comparable companies. That’s how you can ensure that you get a market-relevant valuation that makes sense to investors. You’ll identify a diverse selection of companies for insights into industry benchmarks and reference points.

• You’ll factor in both direct and indirect competitors and business collaborators. This approach provides you with in-depth information on market dynamics and the competitive environment.
• Select companies with similar business models, even if they don’t operate within your sector. This approach will enable a comprehensive analysis of market positions you can capture and the strategies other companies deploy.
• Ensure you obtain the data used in the calculations from verifiable sources, such as industry reports, databases, and financial platforms. Explore platforms such as Crunchbase, the Bloomberg Terminal, or Capital IQ for funding announcements. You’re looking for real numbers and not just theories and estimates. The availability of reliable data can pose a significant challenge to your calculations.
• Be cautious when selecting companies experiencing accelerated growth. Their historical data may not be relevant to your comparative valuation method. These companies will likely have a higher valuation if their profits are estimated to grow faster than those of their competitors.
• If you’re selecting companies from different geographical locations, account for their specific market conditions and regulatory environment. If offshore companies are on your list of comparables, don’t overlook differences in currency values.
• Don’t restrict your comparative analysis to two or three companies. Targeting a broader selection will give you better results.

You’ll adjust the valuation to account for growth potential, development stage, funding stage, market position and other factors. Further, don’t overlook market conditions, as they can affect the startup’s value.

Looking for more information about how to value your company. Check out this video in which I have explained in detail how it’s done.

Advantages of Using the Comparable Valuation Method

There are several advantages to using the comparable valuation method. Here’s a quick look at them.

• The comp-based valuation method is highly versatile and suitable for companies at any growth stage. You can use it for pre-revenue, early-stage, late-stage, and mature companies. As long as a company has comparables and financial projections, you can value it using this method.
• This valuation draws real metrics and data from credible sources, using accurate financial ratios from various companies. This makes the resulting value much more reliable.
• The valuation obtained using this technique reflects investor perspectives about the startup’s potential. You can be confident that they have conducted thorough due diligence before arriving at figures. Using these figures gives you a precise overview of the comparable’s value.
• This method factors in different multiples for companies at varying growth stages. For instance, the EBITDA and revenue multiples for well-established companies, and the enterprise value (EV)/revenue for startups that have yet to generate revenue.
• The multiples method is highly effective since it provides comprehensive insights. You’ll consider direct and indirect competitors, similar business models, peer groups, and market leaders when calculating the valuation.
• When calculating the comparable valuation method, you’ll account for the company’s historical valuation. Or, the valuation obtained during a previous funding round or acquisition. As a result, you’re not just relying on the performances of other companies. But you’re also looking at how your company has been performing.

Disadvantages of Using the Equity Comps Method

Although the comp-based valuation method has several advantages, you can’t overlook the potential challenges. Here’s what you need to know:

• Since every company is unique in various aspects, identifying comparables is difficult.
• This method relies on the data you’ll source from public periodicals and platforms. Compiling this data can be a hurdle because you’ll need the financials of your targeted companies that are comparable to yours. However, if these companies have not disclosed their data, locating it is a challenge. Without these numbers, the comparable valuation method is redundant.
• Selecting comparable companies and making adjustments to account for their differences can be subjective. The analysts’ personal biases can come into play, making the results unreliable.
• Market volatility can lead to significant valuation fluctuations. Relying on these metrics to derive a consistent valuation is impossible.
• Some sectors are more sensitive to market uptrends and downtrends than others. Analysts need to be cautious when selecting companies from such industries.
• More than actual market conditions, investor sentiment can also influence valuations.
• Relying entirely on the comparables’ historical financials and past performances may not be a reliable indicator of their future valuations. Some companies experience rapid growth due to unexpected external factors, such as changes in geopolitical conditions and regulations.
• Similarly, relying on the comparables’ current valuation is not a reliable benchmark. Analysts must account for their growth potential, strategies for further development, and successful funding rounds. For instance, a company developing ground-breaking intellectual property (IP) is likely to generate substantial investor interest. Its valuation is thus expected to appreciate quickly.

In Conclusion

Accurately valuing a company is a complex process and relies on several different variables. The process can be particularly challenging for early-stage startups that don’t have any real metrics to demonstrate. Using the comparables valuation method can level the playing field.

This method can prove to investors that the startup is worth backing. You’ll rely on the financial metrics and performances of comparable companies within your sector. This strategy provides investors with a benchmark against which to evaluate your company and its potential.

At the same time, select the comparable companies carefully. Remember, your objective is to present an accurate overview of what your company can achieve. The numbers should provide comprehensive insight and a broader price range for comparison.

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