Peer group selection in practice

The interviewees use relatively standardised procedures for finding peers. Noteworthy for all is that procedures seem rather manual and cumbersome. The valuation advisor describes the procedure in his team

“We use the search engine in a financial database, in our case we often use Capital IQ from S&P. In this we seek to find an intelligent way to search for companies. First, we define industry. This is usually not enough, because then there are too many. Sometimes we delineate geography, then we use keywords”

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The method used by the investment manager seems to be similar

“[The method] is probably more implicit in people’s minds than it is explicit, as if in a large bank. The process is to find out which industry we are in, and if there are some very well-known companies in that industry, then you use them if they are listed. And you will typically look at the peer groups for those [well-known] companies. This is the go-to method"

The first couple of steps do not include looking at financials and the valuation advisor calls it all “the soft steps”. He emphasises that the keyword search is the most important step in almost all cases, as it is paramount that comparable firms share business description and operate at the same level in the value chain. Oftentimes, if searches are executed based solely on keywords and the search result is 500 potential peers, the valuation advisor finds that the search was defined to broadly.

He emphasises that defining industry is important in order to locate the correct part of the value chain. When the search is narrowed down to a sample that “makes sense” in terms of business description and industry classification, the next step is to look at financials, which is a manual process. In this, the valuation advisor looks at different financial ratios describing capital intensity and financial maturity. The investment manager also uses financials to uncover quantitative similarity among firms, examples include "asset-base, size, margins, and if possible, financials such as investment level, e.g. capital expenditure compared to revenue or the like." Although some of these financials do not necessarily drive a multiple, the valuation advisor and the investment manager utilise them to figure out whether the firms are overall comparable.

The equity research analyst does not have as standardised an approach as the valuation advisor or the investment manager. His approach varies depending on the business of the target firm. Yet, he does focus on industry affiliation, and in particular competitors. Large publicly traded firms will often themselves name their biggest competitors. This would be the starting point for the analyst. If there are no immediate competitors, he will look for companies within the same industry that

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are similar in terms of profitability, growth and risk. In relation to our analysis, this is much like combining the SARD approach with industry affiliation. The equity research analyst notes that the selected peers also are highly dependent on the perceptions of the specific investor, who could be a large institutional investor. He mentions

"[...] then you try to sense what the investor finds appropriate. So a step in the process is also getting feedback from the investor, who can say

"no, we don’t find these to be comparable companies due to this and this and this". Then, there is a need to adjust the selected peers. Sometimes the investors have preconceived perceptions of what types of businesses are appropriate peers or specific companies they regard as comparable."

These comments are interesting to relate to the study of Lee et al. (2015) who has developed a selection method based on co-searched peers. The importance of investors perceptions coincides with the argument put forward by Lee et al.

(2015) that companies who are perceived similar trade at similar prices, despite potential differences in profitability, growth and risk. This stresses the importance of investigating new methods for peer selection based on variables such as co-searched peers.

In terms of peer group size, the valuation advisor explains that they use a system with two peer groups: tier one and tier two. Tier one usually consists of six firms, while tier two is an extra sanity check and consists of approximately 10 firms. The investment manager also uses more than one peer group. The valuation advisor performs the full peer group selection procedure each time, however, if he finds one peer that is "extremely comparable" on every conceivable parameter, he will then argue that the target multiple should be closer to this one peer than the median of the peer group. The equity research analyst makes a similar point. He usually uses five to 10 peers but if one peer is "very much like the target firm compared to the other peers", he also adjusts his valuations such that the target multiple is closer to this single peer than to the rest of the peer group.

In terms of geography, there is a clear tendency that professionals look beyond Danish

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borders when valuing Danish firms. This goes hand in hand with a clear aim to identify head on competition, i.e. companies that operate in the exact same manners and serve the same types of customers. Moreover, many Danish firms operate at a global scale. The interviewed professionals primarily look for comparable firms in Scandinavia, Europe, the US and other developed countries. The equity research analyst notes that it is important that the target and the peers operate in the same market. For example, if he were to value a Danish regional bank, he would compare with other Danish regional banks. On the other hand, if he were to value a large multinational bank in Northen-Europe, he would compare with other large multinational banks, preferably in Northern-Europe, but otherwise in Europe and in the US. In relation to the issue of different accounting standards across boarders, such as IFRS versus US GAAP, the valuation advirsor comments “it’s not all that different.” He underlines that he would rather avoid making corrections, although it may be necessary in some cases.

We identified one situation in the interviewees where the SARD approach does not seem to offer additional advantage over other selection methods. The investment manager uses peer groups to value portfolio companies in relation to the annual audit. These peer groups are held constant over time, i.e. the group is not altered from year to year. When asked about the rationale, the investment manager argues

"You could say that changing the peer group is a little difficult to argue.

Auditors like to adhere to the same principles. It is also clear that there may be some comfort in the fact that once you have settled on companies that are similar and nothing big has happened with the companies from a market perspective... all else being equal, it is still a good peer group."

Using the SARD approach, the peer group will most likely change from year to year as financials typically fluctuate over time. Thus, peers identified using only the SARD approach in one year might not be appropriate peers in the following years, since fundamentals, which are the basis of comparison, may change. This suggests that the SARD approach is not suited for selecting peers, if the purpose of the peer group is to track value development over time.

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