Equity Valuation Using Multiples: An Empirical Investigation

72 Comprehensive multiples valuationthe industry leaders. The results obtained from the hedging peer group, however,only serve as a sanity check and as a mechanism to detect possibly mispriced industryniches.A general advantage of identifying comparables on an industry basis is thatfirms within the same industry tend to have similar capital structures (Ross, Westerfield& Jaffe 2001, p. 451-452). This feature allows us to apply equity value multipleswithout concerns. With this insight, we may generally prefer using equity valuemultiples over entity value multiples because the former are not affected by noise.4.3.3 Size of the peer groupFiltering firms for industry membership, size, and region increases the qualityof comparability – however, the work is still not done. Depending on the specificsituation, the filter process for industry membership, size, and region generates acertain number of potential peers. This number typically lies anywhere betweenzero and twenty firms. If we end up with fewer than two peers, we must either easethe restrictions or use another valuation method. If we have more than two peers, anexamination of financial ratios and multiples of the remaining firms follows (Löhnert& Böckmann 2005, p. 416). First, we check several financial ratios and excludefirms, which are not truly comparable to the target firm. After that, we examine themultiples. Sometimes, the peer group contains firms with negative or meager valuedrivers producing meaningless multiples. In such a situation, we must decidewhether we eliminate only affected multiples or entire firms.A final peer group of two to four firms is somewhat critical from a statisticalpoint of view, but can be rational if the firms’ characteristics are almost identical orwe include a hedging peer group into the valuation. Four to eight comparables is theideal size for a peer group. 38 More than ten peers can easily be misleading, especiallywhen we analyze a broad set of multiples (Pereiro 2002, p. 267). In such acase, I suggest to impose further restrictions to reduce the number of comparables.38 This suggestion is derived from various conversations with academics, (hedge) fund managers,and investment bankers in Europe and the U.S.