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Journal of Accounting Research

Vol. 40 No. 2 May 2002


Printed in U.S.A.

Who Is My Peer? A Valuation-Based


Approach to the Selection of
Comparable Firms
S A N J E E V B H O J R A J A N D C H A R L E S M . C . L E E
Received 4 January 2001; accepted 4 September 2001

ABSTRACT

This study presents a general approach for selecting comparable firms in


market-based research and equity valuation. Guided by valuation theory, we
develop a warranted multiple for each firm, and identify peer firms as those
having the closest warranted multiple. We test this approach by examining
the efficacy of the selected comparable firms in predicting future (one- to
three-year-ahead) enterprise-value-to-sales and price-to-book ratios. Our tests
encompass the general universe of stocks as well as a sub-population of socalled new economy stocks. We conclude that comparable firms selected in
this manner offer sharp improvements over comparable firms selected on the
basis of other techniques.

1. Introduction
Accounting-based market multiples are easily the most common technique in equity valuation. These multiples are ubiquitous in the reports
and recommendations of sell-side financial analysts, and are widely used in
Johnson Graduate School of Management, Cornell University. We thank Bhaskaran
Swaminathan, as well as workshop participants at the Australian Graduate School of Management, Cornell University, Indiana University, the 2001 Journal of Accounting Research Conference, the 2001 HKUST Summer Symposium, Syracuse University, and an anonymous referee,
for helpful comments. The data on analyst earnings forecasts are provided by I/B/E/S International Inc.
407
C , University of Chicago on behalf of the Institute of Professional Accounting, 2002
Copyright 

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investment bankers fairness opinions (e.g., DeAngelo [1990]). They also appear in valuations associated with initial public offerings (IPOs), leveraged
buyout transactions, seasoned equity offerings (SEOs), and other merger
and acquisition (M&A) activities.1 Even advocates of projected discounted
cash flow (DCF) valuation methods frequently resort to using market multiples when estimating terminal values.
Despite their widespread usage, little theory is available to guide the application of these multiples. With a few exceptions, the accounting and finance
literature contains little evidence on how or why certain individual multiples, or certain comparable firms, should be selected in specific contexts.
Some practitioners even suggest that the selection of comparable firms is
essentially an art form that should be left to professionals.2 Yet the degree
of subjectivity involved in their application is discomforting from a scientific
perspective. Moreover, the aura of mystique that surrounds this technique
limits its coverage in financial analysis courses, and ultimately threatens its
credibility as a serious alternative in equity valuation.
In this study, we re-examine the theoretical underpinnings for the use
of market multiples in equity valuation, and develop a systematic approach
for the selection of comparable firms. Our premise is that the popularity
of market-based valuation multiples stems from their function as a classic
satisficing device (Simon [1997]). In using multiples to value firms, analysts forfeit some of the benefits of a more complete, but more complex,
pro forma analysis. In exchange, they obtain a convenient valuation heuristic that produces satisfactory results without incurring extensive time and
effort costs. In fact, we believe it is possible to compensate for much of the
information these multiples fail to capture through the judicious selection
of comparable firms. Our aim is to develop a more systematic technique for
doing so, through an appeal to valuation theory.
Specifically, we argue that the choice of comparable firms should be a
function of the variables that drive cross-sectional variation in a given valuation multiple. For example, in the case of the enterprise-value-to-sales
multiple, comparable firms should be selected on the basis of variables that
drive cross-sectional differences in this ratio, including expected profitability, growth, and the cost-of-capital.3 In this spirit, we use variables nominated by valuation theory and recent advances in estimating the implied
cost-of-capital (i.e., Gebhardt, Lee, and Swaminathan [2001]) to develop a
1

For example, Kim and Ritter [1999] discuss the use of multiples in valuing IPOs. Kaplan
and Ruback [1995] examine alternative valuation approaches, including multiples, in highly
levered transactions.
2 For example, Golz [1986], Woodcock (1992), and McCarthy (1999).
3 We use the enterprise-value-to-sales ratio (EVS) rather than the price-to-sales (PS) ratio
because the former is conceptually superior when firms are differentially levered (we thank the
referee for pointing this out). We also report results for the price-to-book (PB) ratio. We focus
on these two ratios because of their applicability to loss firm, which are particularly important
among the so-called new economy (tech, biotech, and telecommunication) stocks. However,
our approach is general, and can be applied to any of the widely used valuation multiples.

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warranted multiple for each firm based on large sample estimations. We


then identify a firms peers as those firms having the closest warranted
valuation multiple.
Our procedures result in two end products. First, we produce warranted
multiples for each firmthat is, a warranted enterprise-value-to-sales
(WEVS) and a warranted price-to-book (WPB) ratio. These warranted multiples are based on systematic variations in the observed multiples in crosssection over large samples. The warranted multiples themselves are useful
for valuation purposes, because they incorporate the effect of cross-sectional
variations in firm growth, profitability, and cost-of-capital. Second, by ranking firms according to their warranted multiples, we generate a list of peer
firms for each target firm. For investors and analysts who prefer to conduct equity valuation using market multiples, this approach suggests a more
objective method for identifying comparable firms.
For researchers, our approach suggests a new technique for selecting control firms, and for isolating a variable of particular interest. Recent methodology studies have demonstrated that characteristic-matched control samples
provide more reliable inferences in market-based research (e.g., Barber and
Lyon [1997], Lyon et al. [1999]). Our study extends this line of research by
presenting a more precise technique for matching sample firms based on
characteristics identified by valuation theory. Our approach is designed to
accommodate both profitable and loss firms, which have become pervasive
in the so called new economy. In short, the methodology developed in this
paper can be useful whenever the choice of control firms plays a prominent
role in the research design of a market-related study.
We test our approach by examining the efficacy of the selected comparable
firms in predicting future (one- to three-year-ahead) EVS and PB ratios.4 Our
tests encompass the general universe of stocks as well as a sub-population
of new economy stocks from the tech, biotech, and telecommunication
sectors. Our results show that comparable firms selected in this manner
offer sharp improvements over comparable firms selected on the basis of
other techniques, including industry and size matches. The improvement
is most pronounced among the so-called new economy stocks.
The main message from this study is that the choice of comparable firms
can be made more systematic and less subjective through the application of
valuation theory. In the case of the EVS multiple, our approach almost triples
the adjusted r-squares obtained from using simply industry or industry-size
matched selections. The PB multiple is more difficult to predict in general,
but our approach still more than doubles the adjusted r -square relative to
industry or industry-size matched selections. Interestingly, we find that using
the actual multiples from the best comparable firms is generally better than
using the warranted multiple itself. Moreover, the choice of comparable
4 We forecast future multiples because we do not regard the current stock price as necessarily
the best benchmark for assessing valuation accuracy. As discussed later, forecasting future
multiples is not equivalent to forecasting future prices or returns.

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firms is, to some extent, dependent on the market multiple under


considerationthe best firms for the EVS ratio are not necessarily the best
firms for the PB ratio. While we illustrate our approach using these two ratios, this technique can be generalized to other common market multiples,
including: EBITDA/TEV, E/P, CF/P, and others.
In the next section, we further motivate our study and discuss its relation
to the existing literature. In section 3, we develop the theory that underpins
our analysis. In section 4, we discuss sample selection, research design and
estimation procedures. Section 5 reports our empirical results, and section 6
concludes with a discussion of the implications of our findings.

2. Motivation and Relation to Prior Literature


There are at least three situations in which comparable firms are useful.
First, in conducting fundamental analysis, we often need to make forecasts
of sales growth rates, profit margins, and asset efficiency ratios. In these
settings, we typically appeal to comparable firms from the same industry
as a source of reference. Second, in multiples-based valuation, the market
multiples of comparable firms are used to infer the market value of the target
firm. Third, in empirical research, academics seek out comparable firms as
a research design device for isolating a variable of particular interest. Our
paper is focused primarily on the second and third needs for comparable
firms.5
Given their widespread popularity among practitioners, market multiples
based valuation has been the subject of surprisingly few academic studies.
Three recent studies that provide some insights on this topic are Kim and
Ritter (KR; [1999]), Liu, Nissim, and Thomas (LNT; [1999]), and Baker and
Ruback (BR; [1999]). All three examine the relative accuracy of alternative
multiples in different settings. KR uses alternative multiples to value initial
public offers (IPOs), while LNT and BR investigate the more general context
of valuation accuracy relative to current stock prices. KR and LNT both find
that forward earnings perform much better than historical earnings. LNT
shows that in terms of accuracy relative to current prices, the performance
of forward earnings is followed by that of historical earnings measures, cash
flow measures, book value, and finally, sales. In addition, Baker and Ruback
[1999] discuss the advantages of using harmonic meansthat is, the inverse
of the average of inversed ratioswhen aggregating common market multiples. None of these studies address the choice of comparable firms beyond
noting the usefulness of industry groupings.

5 Our technique is not directly relevant to the first situation, because it does not match firms
on the basis of a single attribute (such as sales growth, or profit margin). Instead, our approach
matches firms on the basis of a set of variables suggested by valuation theory. Our paper also
does not address the trivial case whereby a firm is its own comparable. As we point out later, in
multiples-based valuation of public firms, a firms own lagged multiple is often the most useful
empirical proxy for its current multiple.

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Closer to this study are three prior studies that either investigate the effect
of comparable firm selection on multiple-based valuation, or examine the
determinants cross-sectional variations in certain multiples. Boatsman and
Baskin [1981] compare the accuracy of value estimated based on earningsto-price (EP) multiples of firms from the same industry. They find that,
relative to randomly chosen firms, valuation errors are smaller when comparable firms are matched on the basis of historical earnings growth. Similarly,
Zarowin [1990] examines the cross-sectional determinants of EP ratios. He
shows forecasted growth in long-term earnings is a dominant source of variation in these ratios. Other factors, such as risk, historical earnings growth,
forecasted short-term growth, and differences in accounting methods, seem
to be less important.
Finally, Alford [1992] examines the relative valuation accuracy of EP multiples when comparable firms are selected on the basis of industry, size,
leverage, and earnings growth. He finds that valuation errors decline when
the industry definition used to select comparable firms is narrowed to twoor three-digit SIC codes, but that there is no further improvement when a
four-digit classification is used. He also finds that after controlling for industry membership, further controls for firm size, leverage, and earnings
growth do not reduce valuation errors.
Several stylized facts emerge from these studies. First, the choice of which
multiple to use affects accuracy results. In terms of accuracy relative to current prices, forecasted earnings perform relatively well (KR, LNT); the priceto-sales and price-to-book ratios perform relatively poorly (LNT). Second,
industry membership is important in selecting comparable firms (Alford
[1992], LNT, KR). The relation between historical growth rates and EP ratios is unclear, with studies reporting conflicting results (Zarowin [1999],
Alford [1992], Boatsman and Baskin [1981]), but forecasted growth rates
are important (Zarowin [1999]). Other measures, including risk-based metrics (leverage and size) do not seem to provide much additional explanatory
power for E /P ratios.
Our study is distinct from these prior studies in several respects. First, our
approach is more general, and relies more heavily on valuation theory. This
theory guides us in developing a regression model that estimates a warranted multiple for each firm. We then define a firms peers as those firms
with the closest warranted market multiple to the target firm, as identified
by our model. The advantage of a regression-based approach is that it allows
us to simultaneously control for the effect of various explanatory variables.
For example, some firms might have higher current profitability, but lower
future growth prospects, and higher cost-of-capital. This approach allows us
to consider the simultaneous effect of all these variables, and to place appropriate weights on each variable based on empirical relations established
in large samples.
Our empirical results illustrate the advantage of this approach. Contrary
to the mixed results in prior studies, we find that factors related to profitability, growth, and risk, are strongly and consistently correlated with the EVS

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and PB ratios. Collectively, factors that relate to profitability, growth, and


risk, play an important role in explaining cross-sectional variations of these
multiples. In fact, we find that variables related to firm-specific profitability,
forecasted growth and risk are more important than industry membership
and firm size in explaining a firms future EVS and PB ratios.
Second, we employ recent advances in the empirical estimation of cost-ofcapital (i.e., Gebhardt et al. [2001]) to help identify potential explanatory
variables for estimating our model of warranted market multiples. The risk
metrics examined in prior studies are relatively simple, and the results are
mixed. We follow the technique in Gebhardt et al. [2001] to secure additional explanatory variables that are associated with cross-sectional determinants of a firms implied cost-of-capital. Several of these factors turn out to
be important in explaining EVS and PB ratios.
Third, we do not assume that the current stock price of a firm is the
best estimate of firm value. Prior studies compare the valuation derived by
the multiples to a stocks current price to determine the valuation error. In
effect, these studies assume that the current stock price is the appropriate
normative benchmark by which to judge a multiples performance. Under
this assumption, it is impossible to derive an independent valuation using
multiples that is useful for identifying over- or under-valued stocks.
Our less stringent assumption of market efficiency is that a firms current
price is a noisy proxy for the true, but unobservable intrinsic value, defined
as the present value of expected dividends. Moreover, due to arbitrage,
price converges to value over time. As a result, price and various alternative
estimates of value based on accounting fundamentals will be co-integrated
over time.6 Under this assumption, we estimate a warranted multiple that
differs from the actual multiple implicit in the current price. Consistent
with this philosophy, we test the efficacy of alternative estimated multiples
by comparing their predictive power for a firms future multiples (e.g., its
one-, two-, or three-year-ahead EVS and PB ratios).7
Finally, our approach can be broadly applied to loss firms, including many
new economy stocks. Prior studies that examine comparable firms (e.g.,
Alford [1992], Boatsman and Baskin [1981], and Zarowin [1999]) focus
solely on the EP ratio. A limitation of these studies is that they do not pertain to loss firms. This limitation has become more acute in recent years,
as many technology, biotechnology, and telecommunication firms have reported negative earnings.

6 For a more formal statistical model of this co-integrated relationship between price and
alternative estimates of fundamental value, see, Lee, Myers, and Swaminathan [1999].
7 Note that forecasting future multiples is different from forecasting future prices or returns.
In the current context, forecasting future price involves two steps: forecasting future multiples,
and forecasting future fundamentals (e.g., sales or book value per share). Our main interest
is in the stability of the multiples relation, and not in forecasting fundamentals. An example
of fundamental analysis that focuses on forecasting future fundamentals is Ou and Penman
[1989].

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Appendix A provides an indication of the magnitude of the problem.


This appendix reports descriptive statistics for a sample of 3,515 firms from
NYSE/AMEX/NASDAQ as of 5/29/2000. To be included, a firm must be
U.S. domiciled (i.e., not an ADR), have a market capitalization of over
$100 million, and fundamental data for the trailing 12 months (i.e., not
a recent IPO). Based on aggregate net income from the most recent four
quarters, we divide the sample into profitable firms (78% of sample) and
loss firms (22% of sample).
Panel A reports the percentage of these firms that have positive EBIT, Operating Income, EBITDA, Gross Margin, Sales, One-year-ahead forecasted
earnings (FY1), and book value. This panel shows that only 40% of the loss
firms have positive operating income, only 47% have positive EBITDA, and
only 34% have positive FY1 forecasts. In fact, only 87% of the loss firms have
positive gross margins. The only reliably positive accounting measures are
sales (100%) and book value (94%). Clearly, these loss firms are difficult to
value.
However, they are also difficult to ignore. Panel B reports the distribution of realized returns in the past six months (11/31/99 to 5/29/00) separately for the profit firms and loss firms. The returns for the loss firms
have higher mean (19.6% versus 7.8%), higher standard deviation (111.3%
versus 42.3%), and fatter tails. As a group, the loss firms appear to be a
high-stake game that constitutes a substantial proportion of the universe of
traded stocks in the United States.
Our study uses the two most reliably positive multiples (EVS and PB). Liu,
Nissim, and Thomas [1999] show that these two ratios are relatively poor
performers in terms of their valuation accuracy. We demonstrate that by
choosing an appropriate set of comparable firms, the accuracy of these ratios
can be improved sharply. In particular, we demonstrate the incremental
usefulness of the technique for a sub-population of new economy stocks
from the technology, telecom, and biotechnology sectors.

3. Development of the Theory


The valuation literature discusses two broad approaches to estimating
shareholder value. The first is direct valuation, in which firm value is estimated directly from its expected cash flows without appeal to the current
price of other firms. Most direct valuations are based on projected dividends
and/or earnings, and involve a present value computation of future cash
flow forecasts. Common examples are the dividend discount model (DDM),
the discounted cash flow (DCF) model, the residual income model (RIM),
or some other variant.8 The second is a relative valuation approach in

8 We do not discuss liquidation valuation, in which a firm is valued at the breakup value
of its assets. Commonly used in valuing real estate and distressed firms, this approach is not
appropriate for most going concerns.

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which firm value estimates are obtained by examining the pricing of comparable assets. This approach involves applying an accounting-based market multiple (e.g., price-to-earnings, price-to-book, or price-to-sales ratios)
from the comparable firm(s) to our accounting number to secure a value
estimate.9
In relative valuation, an analyst applies the market multiple from a comparable firm to a target firms corresponding accounting number: Our
estimated price = (Their market multiple) X (Our accounting number).
In so doing, the analyst treats the accounting number in question as a summary statistic for the value of the firm. Assuming our firm in its current state
deserves the same market multiple as the comparable firm, this procedure
allows us to estimate what the market would pay for our firm.
Which firm(s) deserve the same multiple as our target firm? Valuation
theory helps to resolve this question. In fact, explicit expressions for most of
the most commonly used valuation multiples can be derived using little more
than the dividend discount model and a few additional assumptions. For
example, the residual income formula allows us to re-express the discounted
dividend model in terms of the price-to-book ratio:10


E t [(ROEt+i r e )Bt+i1 ]
Pt
=1 +
,
Bt
(1 + r e )i Bt
i=1

(1)

where Pt is the present value of expected dividends at time t, Bt = book


value at time t; E t [.] = expectation based on information available at time t;
r e = cost of equity capital; and ROEt+i = the after-tax return on book equity
for period t + i. This equation shows that a firms price-to-book ratio is a
function of its expected ROEs, its cost-of-capital, and its future growth rate in
book value. Firms that have similar price-to-book ratios should have present
values of future residual income (the infinite sum in the right-hand-side of
equation (1)) that are close to each other.
In the same spirit, it is not difficult to derive the enterprise-value-to-sales
ratio in terms of subsequent profit margins, growth rates, and the cost of
capital. In the case of a stable growth firm, the enterprise-value-to-sales ratio
can be expressed as:11
EV t
E t (PMxkx(1 + g))
,
(2)
=
(r g)
St
where EV t is total enterprise value (equity plus debt) at time t, St = total sales at time t; E t [.] = expectation based on information available at
9 A third approach, not discussed here, is contingent claim valuation based on option pricing
theory. Designed for pricing traded assets with finite lives, this approach encounters significant
measurement problems when applied to equity securities. See Schwartz and Moon [2000]
and Kellogg and Charnes [2000] for examples of how this approach can be applied to new
economy stocks.
10 See Feltham and Ohlson [1995] or Lee [1999] and the references therein for a discussion
of this model.
11 See Damodaran [1994; page 245] for a similar expression.

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415

time t; PM is operating profit margin (earnings before interest); k is a constant payout ratio (dividends and debt servicing costs as a percentage of
earnings; alternatively, it is sometimes called one minus the plow-back rate);
r = weighted average cost of capital; and g is a constant earnings growth
rate.
In the more general case, we can model the firms growth in terms of
an initial period (say n years) of high growth, followed by a period of more
stable growth in perpetuity. Under this assumption, a firms enterprise-valueto-sales ratio can be expressed as:


EV t
(1 + g 1 )(1 ((1 + g 1 )n /(1 + r )n ))
= E t PMxkx
r g1
St

(1 + g 1 )n (1 + g 2 )
+
,
(3)
(1 + r )n (r g 2 )
where EV t is the total enterprise value (debt plus equity) at time t, St =
total sales at time t; E t [.] = expectation based on information available
at time t; PM is operating profit margin; k is a constant payout ratio; r =
cost of capital; g 1 is the initial earnings growth rate, which is applied for
n years; and g 2 is the constant growth rate applicable from period n + 1
onwards.
Equation (3) shows that a firms warranted enterprise-value-to-sales ratio
is a function of its expected operating profit margin (PM), payout ratio (k),
expected growth rates (g 1 and g 2 ), and cost of capital (r e ). If the market value
of equity and debt approximates the present value of expected cash flows,
these variables should explain a significant portion of the cross-sectional
variation in the EVS ratio. In the tests that follow, we employ a multiple
regression model to estimate the warranted EVS and PB ratios for each firm.
The explanatory variables we use in the model are empirical proxies for the
key elements in the right-hand side of equations (1) and (3).

4. Research Design
In this section, we estimate annual regressions that attempt to explain the
cross-sectional variation in the EVS and PB ratios. Our goal is to develop a reasonably parsimonious model that produces a warranted multiple (WEVS
or WPB) for each firm. These warranted multiples reflect the large sample
relation between a firms EVS (or PB) ratio and variables that should explain cross-sectional variations in the ratio. The estimated WEVS (or WPB)
becomes the basis of our comparable firm analysis.

4.1

ESTIMATING THE WARRANTED RATIOS

We use all firms in the intersection of (a) the merged COMPUSTAT industrial and research files, and (b) the I/B/E/S historical database of analyst
earnings forecasts, excluding ADRs and REITs. We conduct our analysis
as of June 30th of each year for the period 19821998. To be included

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in the analysis a firm must have at least one consensus forecast of longterm growth available during the 12 months ended June 30th. In the event
that more than one consensus forecast was made in any year, the most
recent forecast is used. We use accounting information for each firm as
of the most recent fiscal year end date, and stock prices as of the end of
June.
To facilitate estimation of a robust model, we drop firms with prices below
$3 per share and sales below $100 million. We eliminate firms with negative
book value (defined as common equity), and any firms with missing price or
accounting data needed for the estimation regression.12 We require that all
firms belong in an industry (based on two-digit SIC codes) with at least five
member firms. In addition we eliminate firms in the top and bottom one
percent of all firms ranked by EVS, PB, Rnoa, Lev, Adjpm, and Adjgro each
year (these variables are defined below). The number of remaining firms in
the sample range from 741 (in 1982) to 1,498 (in 1998).
For each firm, we secure nine explanatory variables. We are guided in
the choice of these variables by the valuation equations discussed earlier,
and several practical implementation principles. First, we wish to construct
a model that can be applied to private as well as public firms, we therefore
avoid using the market value of the target firm in any of the explanatory
variables. Second, in the spirit of the contextual fundamental analysis (e.g.,
see Beneish, Lee, and Tarpley [2000]), we anchor our estimation procedure
on specific industries. In other words, we use the mean industry market
multiples as a starting point, and adjust for key firm-specific characteristics.13
Finally, to the extent possible, we try to use similar variables for estimating
EVS and PB. Our goal is to generate relatively simple models that capture
the key theoretical constructs of growth, risk, and profitability. Specifically,
our model includes the following variables, which are also summarized and
described in more detail in Appendix B:
IndevsThe harmonic mean of the enterprise-value-to-sales multiple for
all the firms with the same two-digit SIC code. For example, for the 1982
regression, this variable is the harmonic mean industry EVS as of June 1,
1982. Enterprise value is defined as total market capitalization of equity,
plus book value of long-term debt. This variable controls for industrywide factors, such as profit margins and growth rates, and we expect
it to be positively correlated with current year firm-specific EVS and PB
ratios.
IndpbThe harmonic mean of the price-to-book ratio for all firms in the
same industry. This variable controls for industry-wide factors that affect
the PB ratio. In addition, Gebhardt et al. [2001] show firms with higher PB
12 The two exceptions are research and development expense and long-term debt. Missing
data in these two fields are assigned a value of zero.
13 More specifically, we use the harmonic means of industry EVS and PB ratios, that is, the
inverse of the average of inversed ratios (see Baker and Ruback [1999]).

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ratios have lower implied costs of capital. To the extent that industries with
lower implied costs-of-capital have higher market multiples, we expect this
variable to be positively correlated with EVS and PB ratios.
AdjpmThe industry-adjusted profit margin. We compute this variable
as the difference between the firms profit margin and the median industry
profit margin. In each case, the profit margin is defined as a firms operating
profit divided by its sales. Theory suggests this variable should be positively
correlated with current year EVS ratios.
LosspmThis variable is computed as Adjpm*Dum, where Dum is 1 if Adjpm
is less than or equal to zero, and 0 otherwise. Used in conjunction with
Adjpm, this variable captures the differential effect of profit margin on the
P/S ratio for loss firms. Prior studies (e.g., Hayn [1995]) show that prices
(and returns) are less responsive to losses than to profits. In univariate tests,
this variable should be positively correlated with EVS and PB. However, controlling for Adjpm, this variable should be negatively correlated with EVS and
PB ratios.
AdjgroIndustry-adjusted growth forecasts. This variable is computed as
the difference between a firms consensus earnings growth forecast (from
IBES) and the industry median of the same. Higher growth firms merit
higher EVS and PB ratios.
LevBook leverage. This variable is computed as the total long-term debt
scaled by the book value of common equity. In univariate tests, Gebhardt
et al. [2001] shows that firms with higher leverage have higher implied costsof-capital. However, controlling for market leverage, they find that book
leverage is not significant in explaining implied cost-of-capital. We include
this variable for completeness, in case it captures elements of cross-sectional
risk not captured by the other variables.
RnoaReturn on net operating asset. This variable is a firms operating
profit scaled by its net operating assets. Penman [2000] recommends this
variable as a measure of a firms core operation profitability. In our context,
having already controlled for profit margins, this variable also serves as a
control for a firms asset turnover. We expect it to be positively correlated
with the EVS and PB ratios.
RoeReturn on equity. This variable is net income before extraordinary
items scaled by the end of period common equity. Conceptually, this variable
should provide a better profitability proxy in the case of the PB ratio. We
use this variable in place of Rnoa as an alternative measure of profitability
when conducting the PB regression.
RdTotal research and development expenditures divided by sales. Firms
with higher R&D expenditures tend to have understated current profitability relative to future profitability. To the extent that this variable captures
profitability growth beyond the consensus earnings forecast growth rate, we
expect it to be positively correlated with the EVS and PB ratios.
In addition to these nine explanatory variables, we also tested three
other variablesa dividend payout measure (actual dividends scaled by

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total assets), an asset turnover measure, and a measure of the standard


deviation of the forecasted growth rate. The first two variables add little to the explanatory power of the model. The standard deviation measure (suggested by Gebhardt et al. [2001] as a determinant of the cost-ofcapital) contributed marginally, but was missing for a significant number
of observations. Moreover, this measure would be unavailable for private
firms. For these reasons, we excluded all three variables from our final
model.
To recap, our research design involves estimating a series of annual
cross-sectional regressions of either the EVS or PB ratio on eight explanatory
variables. The estimated coefficients from last years regressions are used,
in conjunction with each firms current year information, to generate a
prediction of the firms current and future ratio. We refer to this prediction
as a firms warranted multiple (WEVS or WPB). This warranted multiple
becomes the basis for our identification of comparable firms in subsequent
tests.

4.2

DESCRIPTIVE STATISTICS

Table 1 presents annual summary statistics on the two dependent and


nine explanatory variables. The overall average EVS of 1.20 (median of
0.94) and average PB of 2.26 (median of 1.84) are comparable to prior
studies (e.g., LNT, BB), although our sample size is considerably larger due
to the inclusion of loss firms. This table also reveals some trends in the
key variables over time. Consistent with prior studies (e.g., Frankel and
Lee [1999]) we observe an increase over time in the accounting-based
multiples (EVS, PB, Indps, and Indpb) and total R&D expenditures (Rd).
This non-stationarity in the estimated coefficients could be attributable
to systematic changes in the composition of firms over time. For example, the increased importance of the R&D variable could reflect the rising prominence of technology firms in the sample. The accounting-based
rates of return (Rnoa and Roe) and book leverage (Lev) are relatively stable
over time. As expected, the industry-adjusted variables (Adjpm, Losspm, and
Adjgro) have mean and median measures close to zero. Overall, this table indicates that the key input variables for our analysis make economical
sense.
Table 2 presents the average annual pairwise correlation coefficients between these variables. The upper triangle reports Spearman rank correlation
coefficients; the lower triangle reports Pearson correlation coefficients. As
expected, EVS is positively correlated with the industry enterprise-value-tosales ratio (Indevs) and price-to-book ratio (Indpb). It is also positively correlated with industry-adjusted measures of a firms profit margin (Adjpm)
and expected growth rate (Adjgro). It is negatively correlated with book
leverage (Lev), and positively correlated with accounting rates of return
(Rnoa and Roe), as well as R&D expense (Rd). To a lesser degree, EVS
is also positively correlated with profit margin among loss firms (Losspm).
The results are similar for the PB ratio. All the correlation coefficients

WHO IS MY PEER?

419

TABLE 1
Summary Statistics of Estimation Variables
This table provides information on the mean and median of the variables used in the annual
estimation regressions. All accounting variables are from the most recent fiscal year end publicly
available by June 30th. Market values are as of June 30th. EVS is the enterprise value to sales
ratio, computed as the market value common equity plus long-term debt, divided by sales. PB
is the price to book ratio. Indevs is the industry harmonic mean of EVS based on two-digit SIC
codes. Indpb is the industry harmonic mean of PB. Adjpm is the difference between the firms
profit margin and the industry profit margin, where profit margin is defined as operating profit
divided by sales. Losspm is Adjpm indicator variable, where the indicator variable is 1 if profit
margin 0 and 0 otherwise. Adjgro is the difference between the analysts consensus forecast of
the firms long-term growth and the industry average. Lev is the total long-term debt scaled by
book value of stockholders equity. Rnoa is operating profit scaled by net operating assets. Rd is
the firms R&D expressed as a percentage of net sales.
year
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Pooled

EVS

PB

Indevs

Indpb

Adjpm

Losspm

Adjgro

Lev

Rnoa

Roe

Rd

mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median
mean
median

0.63
0.50
0.98
0.77
0.84
0.69
0.88
0.73
1.07
0.88
1.22
1.00
1.09
0.90
1.07
0.89
1.09
0.89
1.10
0.87
1.15
0.94
1.22
1.02
1.20
1.00
1.36
1.07
1.49
1.13
1.51
1.20
1.59
1.24

1.11
0.93
1.82
1.48
1.46
1.26
1.72
1.46
2.14
1.82
2.31
1.92
1.97
1.70
2.02
1.70
1.99
1.64
1.93
1.54
2.13
1.76
2.48
2.04
2.31
1.98
2.49
2.08
2.75
2.24
2.87
2.41
3.06
2.55

0.50
0.50
0.76
0.77
0.69
0.72
0.70
0.72
0.85
0.86
0.95
0.95
0.85
0.80
0.84
0.76
0.83
0.79
0.80
0.69
0.87
0.78
0.90
0.86
0.89
0.86
0.95
0.93
1.01
0.98
1.02
1.07
1.09
1.08

0.92
0.92
1.57
1.59
1.34
1.30
1.45
1.30
1.87
1.69
1.95
1.82
1.69
1.61
1.79
1.63
1.69
1.49
1.65
1.39
1.71
1.52
1.91
1.76
2.02
1.91
2.06
2.02
2.18
1.99
2.12
2.01
2.20
2.05

0.006
0.000
0.002
0.000
0.001
0.000
0.004
0.000
0.001
0.000
0.002
0.000
0.002
0.000
0.003
0.000
0.002
0.000
0.003
0.000
0.005
0.000
0.002
0.000
0.006
0.000
0.007
0.000
0.009
0.000
0.005
0.000
0.004
0.000

0.000
0.000
0.003
0.000
0.004
0.000
0.002
0.000
0.004
0.000
0.007
0.000
0.004
0.000
0.003
0.000
0.004
0.000
0.002
0.000
0.004
0.000
0.002
0.000
0.002
0.000
0.001
0.000
0.002
0.000
0.003
0.000
0.004
0.000

0.50
0.00
0.21
0.05
0.44
0.01
0.66
0.00
0.30
0.04
0.18
0.10
0.29
0.00
0.69
0.00
0.58
0.08
0.45
0.12
0.23
0.19
0.55
0.09
0.49
0.15
0.73
0.00
0.40
0.13
0.36
0.17
0.43
0.00

0.45
0.36
0.49
0.38
0.43
0.33
0.44
0.32
0.50
0.34
0.54
0.40
0.56
0.43
0.57
0.41
0.61
0.44
0.59
0.45
0.59
0.42
0.58
0.39
0.58
0.36
0.56
0.38
0.58
0.37
0.61
0.36
0.63
0.38

20.85
19.62
17.18
16.18
17.85
16.93
19.96
18.82
17.58
16.41
17.27
16.00
19.05
17.68
19.90
18.54
19.77
17.97
19.00
16.93
17.86
15.97
19.80
17.22
20.08
17.47
21.66
18.72
22.19
18.93
21.56
18.97
22.84
20.24

14.39
14.77
11.88
12.82
12.04
13.00
13.49
14.32
11.45
12.92
10.63
12.22
12.61
12.93
13.90
14.71
13.29
13.51
11.91
12.55
10.31
11.29
11.87
12.39
11.57
12.37
13.48
13.18
12.57
13.08
12.46
12.89
12.31
12.76

1.23
0.14
1.33
0.09
1.51
0.08
1.66
0.05
1.75
0.00
1.94
0.00
1.83
0.00
1.94
0.00
1.86
0.00
1.96
0.00
2.03
0.00
1.99
0.00
1.90
0.00
1.77
0.00
2.01
0.00
2.01
0.00
2.25
0.00

mean
median

1.20
0.94

2.26
1.84

0.88
0.81

1.83
1.72

0.004
0.000

0.003
0.000

0.44
0.05

0.56
0.38

20.00
17.96

12.35
13.01

1.86
0.00

are in the expected direction. Except for the correlation between Rnoa
and Roe (which do not appear in the same estimation regression), none
of the average pairwise correlation coefficients exceed 0.60. These results
suggest that the explanatory variables are not likely to be redundant.

420

S. BHOJRAJ AND C. M. C. LEE


TABLE 2
Correlation between Estimation Variables

This table provides the correlation between the variables. The upper triangle reflects the
Spearman correlation estimates; the lower triangle reflects the Pearson correlation coefficients.
All accounting variables are based on the most recent fiscal year end information publicly
available by June 30th. Market values are as of June 30th. EVS is the enterprise value to sales
ratio, computed as the market value common equity plus long-term debt, divided by sales. PB
is the price to book ratio. Indevs is the industry harmonic mean of EVS based on two-digit SIC
codes. Indpb is the industry harmonic mean of PB. Adjpm is the difference between the firms
profit margin and the industry profit margin, where profit margin is defined as operating profit
divided by sales. Losspm is Adjpm indicator variable, where the indicator variable is 1 if profit
margin 0 and 0 otherwise. Adjgro is the difference between the analysts consensus forecast of
the firms long-term growth and the industry average. Lev is the total long-term debt scaled by
book value of stockholders equity. Rnoa is operating profit scaled by net operating assets. Rd is
the firms R&D expressed as a percentage of net sales.
Average Correlation (Pearson/Spearman)
EVS
PB
Indevs
EVS
0.52
0.51
PB
0.47
0.09
Indevs
0.50 0.04
Indpb
0.15 0.28
0.35
Adjpm
0.59 0.33 0.06
Losspm 0.06 0.09
0.02
Adjgro
0.22 0.29 0.01
Lev
0.03 0.07
0.08
Rnoa
0.22 0.54 0.02
Roe
0.23 0.48
0.03
Rd
0.24 0.09
0.10

Indpb Adjpm Losspm Adjgro Lev


Rnoa
Roe
0.16
0.54
0.08
0.21 0.07 0.21 0.28
0.33
0.38
0.14
0.29 0.20 0.60 0.59
0.35 0.07
0.04 0.01
0.06 0.01 0.05
0.03
0.06 0.04 0.14 0.26 0.15
0.02
0.26
0.06 0.17 0.54 0.55
0.04
0.32
0.06 0.03 0.28 0.26
0.05
0.04
0.04
0.01 0.10 0.09
0.09 0.12 0.02
0.02
0.35 0.16
0.25
0.51
0.32
0.07 0.24
0.75
0.14
0.50
0.38
0.07 0.12 0.66
0.06
0.06 0.10
0.09 0.23 0.03 0.06

Rd
0.17
0.08
0.19
0.11
0.03
0.05
0.02
0.27
0.03
0.03

5. Empirical Results
5.1

MODEL ESTIMATION

Table 3 presents the results of annual cross-sectional regressions for each


year from 1982 to 1998. The dependent variable is the enterprise-value-tosales ratio (EVS). The eight independent variables are as described in the
previous section. Table values represent estimated coefficients, with accompanying p-values presented in parentheses. Reported in the right columns
are adjusted r -squares and the number of observations per year. The last two
rows report the average coefficient for each variable, as well as a Newey-West
autocorrelation adjusted t-statistic on the mean of the time series of annual
estimated coefficients.
The results from this table indicate that a consistently high proportion
of the cross-sectional variation in the EVS ratio is captured by the eight
explanatory variables. The annual adjusted r -squares average 72.2%, and
range from a low of 66.1% to a high of 76.5%. The strongest six explanatory variables (Indevs, Adjpm, Losspm, Adjgro, Rnoa, and R&D) have the same
directional sign in each of 17 annual regressions, and are individually significant at less than 1%. Indpb is positively correlated with EVS in 11 out
of 17 years, and is significant at the 5% level. Controlling for Indpb, book

WHO IS MY PEER?

421

TABLE 3
Annual Estimation Regressions for Warranted Enterprise-Value-to-Sales
This table reports the results from the following annual estimation regression:
EVSi,t = at +

8


j,t C j,i,t + i,t

j =1

where the dependent variable, EVS, is the enterprise value to sales ratio as of June 30th of each
year. The eight explanatory variables are as follows: Indevs is the industry harmonic mean of
EVS based on two-digit SIC codes; Indpb is the industry harmonic mean of the price-to-book
ratio; Adjpm is the difference between the firms profit margin and the industry profit margin,
where profit margin is defined as operating profit divided by sales; Losspm is Adjpm indicator
variable, where the indicator variable is 1 if profit margin 0 and 0 otherwise; Adjgro is the
difference between the analysts consensus forecast of the firms long-term growth rate and the
industry average; Lev is long-term debt scaled by book equity; Rnoa is operating profit as a
percent of net operating assets; and Rd is R&D expense as a percentage of sales. P -values are
provided in parentheses. The last row represents the time-series average coefficients along with
Newey-West autocorrelation corrected t-statistics. The adjusted r -square (r -sq) and number of
firms (# obs) are also reported.
Year Intercept
1982 0.0623
(0.135)
1983 0.0883
(0.121)
1984
0.0192
(0.699)
1985
0.1337
(0.002)
1986
0.0225
(0.706)
1987
0.1899
(0.007)
1988
0.1774
(0.00)
1989 0.0455
(0.347)
1990
0.1083
(0.027)
1991
0.2321
(0.00)
1992
0.2064
(0.00)
1993
0.1811
(0.004)
1994
0.2698
(0.00)
1995
0.3148
(0.00)
1996
0.0713
(0.249)
1997
0.1192
(0.048)
1998 0.0269
(0.683)
All
0.1072
(0.007)

Indevs

Indpb

1.2643
(0.00)
1.3531
(0.00)
1.2778
(0.00)
1.2231
(0.00)
1.3202
(0.00)
1.0908
(0.00)
1.0759
(0.00)
1.1264
(0.00)
1.1263
(0.00)
1.0740
(0.00)
0.8277
(0.00)
1.0169
(0.00)
1.0027
(0.00)
1.0355
(0.00)
1.1690
(0.00)
1.1714
(0.00)
1.0157
(0.00)
1.1277
(0.00)

0.1648
(0.00)
0.0301
(0.342)
0.0015
(0.964)
0.0152
(0.604)
0.0047
(0.856)
0.0324
(0.339)
0.0097
(0.63)
0.0828
(0.00)
0.0322
(0.019)
0.0256
(0.079)
0.1150
(0.00)
0.0579
(0.097)
0.0027
(0.913)
0.0211
(0.512)
0.0430
(0.141)
0.0366
(0.264)
0.1561
(0.00)
0.0360
(0.031)

Adjpm

Losspm

6.3052 2.8510
(0.00)
(0.119)
8.1343 5.3800
(0.00)
(0.00)
6.9266 4.2894
(0.00)
(0.00)
7.9394 4.0951
(0.00)
(0.00)
9.4308 6.2424
(0.00)
(0.00)
9.8090 6.8296
(0.00)
(0.00)
8.6458 6.9959
(0.00)
(0.00)
8.4475 5.3691
(0.00)
(0.00)
9.3485 6.0607
(0.00)
(0.00)
10.4789 6.9779
(0.00)
(0.00)
10.2810 7.9414
(0.00)
(0.00)
11.4266 6.4058
(0.00)
(0.00)
10.6165 7.1717
(0.00)
(0.00)
11.9432 9.2245
(0.00)
(0.00)
11.331110.6464
(0.00)
(0.00)
12.5771 7.5521
(0.00)
(0.00)
13.030910.1430
(0.00)
(0.00)
9.8043 6.7162
(0.00)
(0.00)

Adjgro

Lev

Rnoa

Rd

R-sq

# Obs

0.0117
(0.00)
0.0392
(0.00)
0.0209
(0.00)
0.0177
(0.00)
0.0316
(0.00)
0.0363
(0.00)
0.0267
(0.00)
0.0225
(0.00)
0.0346
(0.00)
0.0316
(0.00)
0.0329
(0.00)
0.0333
(0.00)
0.0312
(0.00)
0.0419
(0.00)
0.0623
(0.00)
0.0452
(0.00)
0.0421
(0.00)
0.0330
(0.00)

0.0665
(0.007)
0.1414
(0.00)
0.0707
(0.012)
0.0238
(0.351)
0.0246
(0.325)
0.0608
(0.035)
0.0228
(0.27)
0.0143
(0.409)
0.0381
(0.065)
0.0430
(0.06)
0.0567
(0.004)
0.0129
(0.515)
0.0219
(0.202)
0.0100
(0.618)
0.0001
(0.996)
0.0201
(0.278)
0.0362
(0.069)
0.0184
(0.235)

0.0091
(0.00)
0.0049
(0.004)
0.0088
(0.00)
0.0089
(0.00)
0.0080
(0.00)
0.0041
(0.014)
0.0054
(0.00)
0.0032
(0.01)
0.0037
(0.005)
0.0053
(0.00)
0.0037
(0.008)
0.0045
(0.00)
0.0060
(0.00)
0.0069
(0.00)
0.0023
(0.121)
0.0032
(0.011)
0.0006
(0.637)
0.0052
(0.00)

0.0194
(0.00)
0.0463
(0.00)
0.0197
(0.00)
0.0153
(0.00)
0.0118
(0.01)
0.0319
(0.00)
0.0281
(0.00)
0.0127
(0.00)
0.0191
(0.00)
0.0134
(0.00)
0.0157
(0.00)
0.0253
(0.00)
0.0254
(0.00)
0.0680
(0.00)
0.0244
(0.00)
0.0313
(0.00)
0.0229
(0.00)
0.0253
(0.00)

74.40

741

70.80

748

73.45

771

74.66

797

71.11

799

66.84

856

75.44

787

74.58

813

73.54

829

76.45

855

71.63

902

71.31

978

73.19 1102
75.37 1190
66.05 1341
71.75 1440
66.65 1498
72.19 16447

422

S. BHOJRAJ AND C. M. C. LEE

leverage (Lev) is not significantly correlated with EVS. Collectively, these


results show that growth, profitability, and risk factors are incrementally important in explaining EVS ratios, even after controlling for industry means.
Note that the estimated coefficients on several of the key explanatory variables change systematically over time. For example, the estimated coefficient
on the industry adjusted profit margin (Adjpm) and forecasted growth rate
(Adjgro) both trend upwards over time, while the coefficient on the industry
enterprise-value-to-sales ratio (Indevs) shows some decline in recent years.
These patterns imply that, in forecasting future EVS ratios, the estimated coefficients from the most recent year is likely to perform better than a rolling
average of past years. In subsequent analyses, we use the estimated coefficients from the prior years regression to forecast current years warranted
multiple.
Table 4 reports the results of annual cross-sectional regressions for the PB
ratio. The explanatory variables are the same as for the EVS regression in
table 3, except for the replacement of Rnoa with Roe. Table 4 shows that all
the variables except Lev contribute significantly to the explanation of PB.
The coefficient on Indps is reliably negative. Otherwise, the variables are
correlated with PB in the same direction as expected. Overall, the model
is less successful at explaining PB than at explaining EVS. Nevertheless, the
average adjusted r -square is still 51.2%, ranging from a low of 32.8% to a
high of 61.0%.

5.2

FORECASTING FUTURE RATIOS

Recall that our goal is to identify comparable firms that will help us to
forecast a target firms future price-to-sales multiples. In this section, we examine the efficacy of the warranted multiple approach in achieving this
goal. Specifically, we examine the relation between a firms future EVS
and PB ratios, and a number of ex ante measures based on alternative
definitions of comparable firms. The key variables in this analysis are defined
below.
EVSn and PBn, where n = 0, 1, 2, and 3The current, one-, two-, and
three-year-ahead EVS and PB ratios. These are our dependent variables.
IEVS and IPBThe harmonic mean of the industry EVS and PB ratios, respectively. Industry membership is defined in terms of two-digit SIC
codes.
ISEVS and ISPBThe harmonic mean of the actual EVS and PB ratios for
the four firms from the same industry with the closest market capitalization.
WEVS and WPBThe warranted EVS and PB ratios. These variables are
computed using the estimated coefficients from the prior years regression
(tables 3 and 4), and accounting or market-based variables from the current
year.
COMPActual EVS (or PB) ratio for the closest comparable firms. This
variable is the harmonic mean of the actual EVS (or PB) ratio of the four
closest firms based on their warranted multiple. To construct this variable,

WHO IS MY PEER?

423

TABLE 4
Annual Estimation Regressions for Warranted Price-to-Book
This table reports the results from the following annual estimation regression:
PBi,t = at +

8


j,t C j,i,t + i,t

j =1

where the dependent variable, PB, is the price-to-book ratio as of June 30th of each year. The
eight explanatory variables are as follows: Indevs is the industry harmonic mean of EVS based
on two-digit SIC codes; Indpb is the industry harmonic mean of the price-to-book ratio; Adjpm
is the difference between the firms profit margin and the industry profit margin, where profit
margin is defined as operating profit divided by sales; Losspm is Adjpm Dum, where Dum is 1
if profit margin 0 and 0 otherwise; Adjgro is the difference between the analysts consensus
forecast of the firms long-term growth rate and the industry average; Lev is long-term debt
scaled by book equity; Roe is net income before extraordinary items as a percent of book
equity; and Rd is R&D expense as a percentage of sales. The p-values are provided below each
of the coefficients in parentheses. The last row represents the time-series average coefficients
along with Newey-West autocorrelation corrected t- statistics. The adjusted r -square (r -sq) and
number of firms (# obs) are also reported.
Year Intercept
1982 0.2990
(0.00)
1983 0.3434
(0.00)
1984 0.1065
(0.143)
1985 0.3518
(0.00)
1986
0.0998
(0.319)
1987
0.0632
(0.584)
1988
0.0568
(0.566)
1989 0.3306
(0.001)
1990 0.4592
(0.00)
1991
0.0459
(0.613)
1992
0.1797
(0.098)
1993
0.2426
(0.111)
1994 0.0187
(0.881)
1995 0.3095
(0.008)
1996 0.0713
(0.569)
1997
0.1104
(0.402)
1998
0.0247
(0.87)
All
0.0863
(0.169)

Indevs

Indpb

0.6056
(0.00)
0.5129
(0.001)
0.1806
(0.099)
0.2882
(0.009)
0.3548
(0.005)
0.6468
(0.00)
0.5150
(0.00)
0.5790
(0.00)
0.9002
(0.00)
0.9010
(0.00)
0.6645
(0.00)
0.5925
(0.00)
0.4753
(0.00)
0.2491
(0.00)
0.3475
(0.00)
0.3565
(0.00)
0.3666
(0.00)
0.5021
(0.00)

1.1601
(0.00)
1.1696
(0.00)
0.9401
(0.00)
1.0448
(0.00)
0.9866
(0.00)
1.0956
(0.00)
0.8393
(0.00)
1.1269
(0.00)
1.3508
(0.00)
1.0963
(0.00)
1.0051
(0.00)
0.7907
(0.00)
1.0234
(0.00)
0.9481
(0.00)
1.0319
(0.00)
0.8816
(0.00)
1.0553
(0.00)
1.0321
(0.00)

Adjpm

Losspm

2.0331 6.2544
(0.00)
(0.00)
3.289111.9301
(0.00)
(0.00)
2.0887 5.9880
(0.00)
(0.00)
3.0154 8.6571
(0.00)
(0.00)
3.6912 6.4419
(0.00)
(0.00)
6.0189 9.8553
(0.00)
(0.00)
2.0184 9.9218
(0.00)
(0.00)
2.602315.3872
(0.00)
(0.00)
1.928010.8096
(0.00)
(0.00)
3.082010.7620
(0.00)
(0.00)
3.527212.3146
(0.00)
(0.00)
1.628013.7791
(0.005) (0.00)
3.1253 9.8989
(0.00)
(0.00)
4.3329 9.7318
(0.00)
(0.00)
4.073013.0282
(0.00)
(0.00)
3.879013.5652
(0.00)
(0.00)
3.7902 7.1481
(0.00)
(0.00)
3.183710.3220
(0.00)
(0.00)

Adjgro

Lev

Roe

Rd

0.0371
(0.00)
0.1147
(0.00)
0.0527
(0.00)
0.0568
(0.00)
0.0883
(0.00)
0.0881
(0.00)
0.0694
(0.00)
0.0576
(0.00)
0.0815
(0.00)
0.0744
(0.00)
0.0781
(0.00)
0.0939
(0.00)
0.0834
(0.00)
0.0908
(0.00)
0.1221
(0.00)
0.0948
(0.00)
0.0852
(0.00)
0.0805
(0.00)

0.2245
(0.00)
0.1545
(0.01)
0.2302
(0.00)
0.2694
(0.00)
0.3075
(0.00)
0.0583
(0.221)
0.0675
(0.083)
0.0474
(0.176)
0.0663
(0.073)
0.1227
(0.001)
0.0018
(0.969)
0.1131
(0.02)
0.1650
(0.00)
0.0409
(0.284)
0.1303
(0.006)
0.1596
(0.00)
0.2276
(0.00)
0.0349
(0.511)

0.0402
(0.00)
0.0541
(0.00)
0.0397
(0.00)
0.0585
(0.00)
0.0542
(0.00)
0.0459
(0.00)
0.0666
(0.00)
0.0574
(0.00)
0.0644
(0.00)
0.0683
(0.00)
0.0593
(0.00)
0.0828
(0.00)
0.0521
(0.00)
0.0735
(0.00)
0.0649
(0.00)
0.0837
(0.00)
0.0674
(0.00)
0.0608
(0.00)

0.0418
(0.00)
0.0627
(0.00)
0.0314
(0.00)
0.0013
(0.845)
0.0053
(0.528)
0.0323
(0.001)
0.0266
(0.001)
0.0111
(0.122)
0.0144
(0.08)
0.0052
(0.477)
0.0203
(0.007)
0.0468
(0.00)
0.0436
(0.00)
0.0742
(0.00)
0.0147
(0.133)
0.0248
(0.006)
0.0341
(0.00)
0.0282
(0.00)

R-sq # Obs
55.78

832

60.99

852

57.83

319

59.15

956

56.55

954

52.97 1019
54.15

940

52.19

999

53.16 1023
54.88 1041
48.51 1089
46.82 1188
44.96 1349
53.52 1447
42.76 1628
43.00 1723
32.82 1828
51.18 19187

424

S. BHOJRAJ AND C. M. C. LEE

we rank all the firms each year on the basis of their WEVS (or WPB), and
compute the harmonic mean of the actual EVS (or PB) for these firms.
ICOMPActual EVS (or PB) ratio for the closest comparable firms within
the industry. This variable is the harmonic mean of the actual EVS (or PB)
ratio of the four firms within the industry with the closest warranted multiple.
Essentially, this is the COMP variable with the firms constrained to come
from the same industry.
In short, we compute five different EVS (or PB) measures for each firm
based on alternative methods of selecting comparable firms. IEVS and
ISEVS (or, IPB and ISPB) correspond to prior studies that control for industry membership and firm size. The other measures incorporate risk,
profitability, and growth characteristics beyond industry and size controls.
We then examine their relative power in forecasting future EVS and PB
ratios.
As an illustration, Appendix C presents selection details for Guidant Corporation (GDT), a manufacturer of medical devices. This appendix illustrates the set of firms in the same two-digit SIC code, which are identified
as peers of Guidant based on data as of April 30, 2001. Panel A reports the
six closest firms based on WEVS, Panel B reports the closest firms based
on WPB. We reviewed this list with a professional analyst who covers this
sector. She agreed with most of the selections but questioned the absence
of St. Jude Medical Devices (STJ), which she regarded as a natural peer.
She agreed with our choices, however, after we discussed the profitability,
growth, and risk characteristics of STJ in comparison to those of the firms
listed.
Table 5 reports the results for a series of forecasting regressions. In
panel A, the dependent variable is EVSn, and in panel B, the dependent
variable is PBn; where n = 0, 1, 2, 3, indicates the number of years into the
future. In each case, we regress the future market multiple on various ex
ante measures based on alternative definitions of comparable firms.14 The
table values represent the estimated coefficient for each variable averaged
across 14 (n = 3) to 17 (n = 0) annual cross-sectional regressions. The bottom row reports the average adjusted r-square of the annual regressions for
each model.
These results show that the harmonic mean of the industry-matched firms
explains 17.5% (three-year-ahead) to 22.9% (current year) of the crosssectional variation in future EVS ratios. Including the mean EVS ratio from
the closest four firms matched on size increases the adjusted r-squares only
marginally, so that collectively IEVS and ISEVS explain 18% to 23% of the
variation in future EVS ratios. These results confirm prior evidence on the
usefulness of industry-based comparable firms. However, they also show that
14 Even for the current year (n = 0), the warranted multiples are based on estimated coefficients from the prior years regression. Therefore, the models that involve warranted multiples
are all forecasting regressions.

TABLE 5
Prediction Regressions
This table provides average estimated coefficients from the following prediction regressions:
EVSi,t+k = at +

n


j,t C j,i,t + i,t

PBi,t+k = at +

n


j =1

j,t C j,i,t + i,t

j =1

where k = 0, 1, 2, 3. In Panel A, the dependent variable is the enterprise-value-to-sales ratio (EVS). In Panel B, the dependent variable is the price-to-book
ratio (PB). The expanatory variables are: IEVS, the harmonic mean of the industry EVS based on current year (k = 0), but excluding the target firm; ISEVS,
the harmonic mean of the actual EVS for the four closest firms matched on size after controlling for industry; WEVS, the firms warranted EVS, determined
using the coefficients derived from last years estimation regressions and current year accounting and market-based variables; COMP, the harmonic mean of
the actual EVS for the four closest firms matched on WEVS; and ICOMP, the harmonic mean of the actual EVS for the four closest firms matched on WEVS
after controlling for industry. The variables for Panel B are defined analogously, replacing EVS with PB. Table values represent the time-series average of the
coefficients from annual cross-sectional regressions. The bottom row reports the average adjusted r -square of the annual regressions.

20.75

0.46
1.17

7.62

One year ahead EVS


0.23
0.07
0.01
0.01
1.05
0.16 0.17 0.16
0.14
0.12
0.14
0.12
0.83
0.13
0.93
0.80
0.27
21.24 46.14 51.97 53.23
One year ahead PB
0.40
0.15
0.04
1.00
0.38
0.12
0.18
0.14
0.13
0.65
0.29
0.59
8.02

19.91

22.94

0.05
0.12
0.10
0.51
0.40
23.38

0.27
1.18

18.37

0.57
1.16

5.01

Two year ahead EVS


0.25
0.10
0.03
0.04
1.06
0.20 0.11 0.11
0.13
0.11
0.13
0.10
0.81
0.12
0.91
0.75
0.30
18.79 40.33 45.48 46.67
Two year ahead PB
0.50
0.28
0.20
0.96
0.35
0.12
0.21
0.17
0.16
0.62
0.30
0.53
5.47

12.52

14.04

0.18
0.11
0.13
0.49
0.39
14.71

0.30
1.19

17.49

0.80
1.06

4.07

Three year ahead EVS


0.28
0.12
0.06
0.07
1.04
0.20 0.12 0.10
0.15
0.15
0.17
0.14
0.79
0.09
0.92
0.70
0.33
17.99 36.80 41.48 43.09
Three year ahead PB
0.73
0.54
0.46
0.82
0.27
0.06
0.25
0.21
0.20
0.56
0.29
0.46
4.50

9.81

11.03

0.45
0.06
0.17
0.46
0.33
11.32

425

Panel B: Book-value-to-sales
Current year PB
Inter
0.40
0.35
0.07 0.06 0.07
IPB
1.19
1.04
0.26 0.09 0.07
ISPB
0.16
0.11
0.10
0.07
COMP
0.81
0.35
WPB
0.77
0.71
ICOMP
0.44
r -sq
11.80 12.34 35.21 41.94 43.20

0.24
1.19

WHO IS MY PEER?

Panel A: Enterprise-value-to-sales
Current year EVS
Inter
0.24
0.22
0.06
0.00
0.00
IEVS
1.19
1.02
0.08 0.27 0.26
ISEVS
0.16
0.14
0.16
0.13
COMP
0.89
0.16
WEVS
0.98
0.83
ICOMP
0.33
r -sq
22.94 23.46 54.71 61.68 62.99

426

S. BHOJRAJ AND C. M. C. LEE

the valuation accuracy of industry-based EVS ratios leaves much to be desired. In fact, industry-size based comparable firms explain less than 20% of
the variation in two-year-ahead EVS ratios.
The predictive power of the model increases sharply with the inclusion of
variables based on the warranted EVS ratio (WEVS). On average, a model that
includes IEVS, ISEVS, and COMP explains over 40% of the cross-sectional
variation in two-year-ahead EVS ratios. Including WEVS in the model increases the average adjusted r -square on the two-year-ahead regressions to
45.5%. Moreover, even after controlling for WEVS, the actual WEVS ratio
of the closest comparable firms (COMP or ICOMP) is incrementally useful
in predicting future EVS ratios. It appears that comparable firms selected
on the basis of their WEVS adds to the prediction of future EVS ratios even
after controlling for WEVS itself. COMP and ICOMP yield similar results. A
model that includes IEVS, ISEVS, WEVS, and ICOMP explains between 63.0%
(current year) and 43.1% (three-year-ahead) of the variation in future EVS
ratios.15
Panel B reports forecasting regressions for PB. Compared to EVS, a much
smaller proportion of the variation in PB is captured by these models. In
the current year, the combination of IPB and ISPB explains only 12.3% of
the variation in PB. The inclusion of WPB and ICOMP increases the adjusted
r -square to 43.2%. In future years, the explanatory power of all the models
declines sharply. However, over all forecast horizons, models based on warranted multiples explain more than twice the variation in future PB ratios
as compared to the industry-size matched model.
The rapid decay in the explanatory power of the PB model is a possible
concern with these results. Either PB ratios are difficult to forecast, or our
model is missing some key forecasting variables. To shed light on this issue,
we report below the serial correlation in annual EVS and PB ratios. Table values in the chart below are average Pearson correlation coefficients between
the current years ratio, and the same ratio one, two, or three years later.
Average Correlation Coefficient

EVS0
PB0

EVS1

EVS2

EVS3

PB1

PB2

PB3

0.87

0.79

0.73

0.72

0.56

0.44

These results show that with a one-year lag, EVS is serially correlated at 0.87,
suggesting an r -square of around 76%. With a three-year lag, EVS is serially
correlated at 0.73, suggesting an r -square of 53%. Similarly, with a one-year
lag, PB is serially correlated at 0.72, suggesting an r -square of 52%. With
15 We also conducted year-by-year analysis to examine the stability of these results over time.
We find that a model that includes IEVS, ISEVS, WEVS, and ICOMP is extremely consistent in
predicting future EVS ratios. All four variables are incrementally important in predicting future
EVS ratios in each forecasting period.

WHO IS MY PEER?

427

a three-year lag, PB is serially correlated at 0.44, suggesting an r -square of


only 19.4%. These results show that PB is in fact inherently more difficult to
forecast than EVS. Even when we know a firms current PB ratio, we can only
explain a relatively small proportion of the variation in future PB ratios.16
Two results from table 5 deserve emphasis. First, this table shows that the
common practice of using industry and/or industry-size based comparable
firms performs relatively poorly in predicting a firms EVS and PB ratios. Only
around 18% (4.5%) of the cross-sectional variation in three-year-ahead EVS
(PB) ratios is captured by this approach. These results re-enforce the finding in LNT, in which the price-to-sales and price-to-book ratios of industrymatched firms generates relatively high valuation errors when compared
to the target firms current market price. Later, we provide a more direct
comparison based on the distribution of valuation errors.
Second, these tables show that firms identified on the basis of a warranted
EVS or warranted PB (i.e., firms matched on the basis of a weighted average of
eight variables including profit margin, growth, and determinants of cost-ofcapital) offer a much better benchmark for comparison. With the inclusion
of the warranted multiple (either WEVS or WPB) and the actual multiples of
comparable firms (either COMP or ICOMP), the adjusted r -square increases
sharply. In fact, 43% (11.3%) of the variation in three-year-ahead EVS (PB)
ratio can be predicted. This result suggests that by systematically matching
firms on the basis of their warranted multiples, we can identify superior
comparable firms.
Prior studies generally computed a distribution of valuation errors for
various prediction measures, expressed as a proportion of the actual priceper-share. To facilitate comparison, table 6 reports these valuation errors for
our firms. Panel A reports the results for EVS, and Panel B reports the results
for PB. In each case, we provide separate results for n = 0 through 3. We also
compare the errors for an industry-size matched model (ISEVS or ISPB)
to a model using warranted multiples (WEVS or WPB) and a model using
industry constrained comparables selected on the basis of their warranted
multiples (ICOMP). We report the Absolute Error (the absolute difference
between actual and implied price, scaled by the actual price), as well as the
Bias (the actual price minus the implied price, scaled by the actual price).17
Panel A shows that the median absolute error for the industry-size
matched firms in the current year is 0.55. This is slightly higher than the
absolute error reported by LNT. However, the difference is not surprising,

16 As expected, the lagged multiple has strong predictive power for the current multiple.
This result suggests that, for public firms, investors should use a firms own lagged multiple
as a predictor of its future multiples. However, this approach cannot be used to value private
firms, nor can it be used to identify control firms for research purposes.
17 In each case, the implied price for the warranted multiples is based on the coefficients
estimated in year n = 1, applied to the accounting and market-related variables obtained in
the future (n = 0, 1, 2, or 3).

428

S. BHOJRAJ AND C. M. C. LEE


TABLE 6
Distribution of Valuation Errors

This table presents the distribution of valuation errors for various prediction measures, expressed as a proportion of actual price-per-share. EVSk is the k year ahead enterprise-value-tosales ratio. PBn is the k year ahead price-to-book ratio. The expanatory variables are: ISEVS,
the harmonic mean of the actual EVS for the four closest firms matched on size after controlling for industry, measured as of the current year (k = 0); WEVS, the firms warranted EVS, is
determined using the coefficients derived from last years estimation regressions (k = 1) and
current year accounting and market-based values (k = 0); and ICOMP, the harmonic mean of
the actual EVS for the four closest firms matched on WEVS after controlling for industry. The
variables for Panel B are defined analogously, replacing EVS with PB. Absolute Error is the
absolute difference between actual and implied price, scaled by actual price. Bias is the actual
price minus the implied price, scaled by the actual price. Table values represent the mean,
median, inter-quartile range (IQRange), 90th-percentile minus 10th-percentile (90%10%),
and 95th-percentile minus 5th-percentile (95%5%).
Absolute Error

Bias

IQ 90% 95%
IQ 90% 95%
Mean Median Range 10%
5% Mean Median Range 10%
5%
Panel A: Enterprise-Value-to-Sales
EVS0 ISEVS
0.86
0.55
0.58
WEVS
0.61
0.35
0.51
ICOMP 0.57
0.36
0.45

1.62
1.24
1.01

2.75
1.91
1.68

0.27
0.22
0.12

0.13
0.04
0.08

1.09
0.75
0.70

2.44
1.68
1.55

3.67
2.53
2.36

EVS1 ISEVS
0.89
WEVS
0.67
ICOMP 0.63

0.56
0.41
0.40

0.72
0.60
0.55

1.69
1.32
1.18

2.73
1.99
1.79

0.22
0.18
0.08

0.12
0.05
0.07

1.11
0.83
0.79

2.57
1.88
1.73

3.91
2.80
2.62

EVS2 ISEVS
0.89
WEVS
0.70
ICOMP 0.66

0.58
0.43
0.43

0.76
0.65
0.60

1.74
1.40
1.27

2.66
2.08
1.85

0.15
0.13
0.02

0.12
0.03
0.08

1.12
0.88
0.84

2.57
1.99
1.83

3.87
2.98
2.76

EVS3 ISEVS
0.91
WEVS
0.71
ICOMP 0.69

0.59
0.45
0.44

0.80
0.66
0.63

1.78
1.42
1.34

2.64
2.13
2.00

0.08
0.09
0.03

0.15
0.03
0.08

1.13
0.91
0.88

2.58
2.03
1.93

3.93
3.02
2.85

Panel B: Price-to-Book
PB0 ISPB
0.55
0.38
WPB
0.48
0.30
ICOMP 0.44
0.29

0.46
0.41
0.38

0.91
0.93
0.74

1.54
1.44
1.19

0.12
0.14
0.08

0.09
0.02
0.08

0.74
0.62
0.56

1.61
1.35
1.25

2.30
1.99
1.84

PB1

ISPB
0.60
WPB
0.54
ICOMP 0.51

0.41
0.36
0.35

0.54
0.50
0.47

1.13
1.06
0.96

1.66
1.56
1.41

0.07
0.10
0.03

0.08
0.02
0.08

0.79
0.72
0.68

1.73
1.55
1.48

2.54
2.27
2.15

PB2

ISPB
0.62
WPB
0.57
ICOMP 0.56

0.43
0.39
0.39

0.58
0.55
0.53

1.19
1.15
1.09

1.73
1.63
1.53

0.00
0.04
0.03

0.11
0.00
0.10

0.82
0.78
0.75

1.80
1.67
1.60

2.62
2.42
2.34

PB3

ISPB
0.65
WPB
0.60
ICOMP 0.59

0.44
0.40
0.40

0.61
0.57
0.57

1.27
1.19
1.16

1.82
1.76
1.66

0.06
0.02
0.09

0.13
0.01
0.11

0.84
0.81
0.79

1.83
1.74
1.68

2.69
2.52
2.43

as LNT requires all accounting variables (including earnings and forecasted


earnings) to be positive while we do not. In fact, our sample size is approximately twice as large as theirs. More important is the comparison between
ISEVS and the warranted multiple models (WEVS and ICOMP). The median

WHO IS MY PEER?

429

absolute error for the implied price based on WEVS (ICOMP) is sharply
lower at 0.35 (0.36). The advantage of the warranted multiples approach is
sustained in years n = 1, 2, and 3. The bias is also lower for WEVS and ICOMP
across all forecasting horizons. In short, the implied prices computed based
on warranted multiples produce valuation errors with lower means, a tighter
inter-quartile range, and less fat-tailed distributions. The results in panel B
show similar findings for the PB ratio. Collectively these results support the
earlier findings based on adjusted r -squares.

5.3

NEW ECONOMY STOCKS

In this section, we estimate warranted enterprise-value-to-sales and priceto-book ratios for firms in so-called new economy sectors. We define these
as firms within the following two-digit SIC code categories: biotechnology
(28332836 and 87318734), computers (35703577 and 73717379), electronics (36003674) and telecommunication (48104841). This technologydominated sample is characterized by a higher proportion of growth firms
and firms that are not currently earning a profit. We are particularly interested in the robustness of our method in valuing the firms in this subsample.
Table 7 reports the year-by-year EVS estimation results for these technology
firms. This table shows that the same eight explanatory variables explain
a consistently large proportion of the variation in EVS ratios across these
firms. The average adjusted r -square for this population is 70.1%, which is
only marginally lower than the average adjusted r-square of 72.2% for the
overall population. Annually, the explanatory power of the model ranges
from 63.1% to 84.9%, suggesting a good fit every year.
Across the eight variables, the estimated coefficients for the technology
firms are strikingly different from those for the overall population. Three
variablesthe industry PB ratio (Indpb), leverage (Lev), and return on net
operating asset (Rnoa)have much lower estimated coefficients in this
sample. In fact, these variables are not individually significant at the 5%
level. On the other hand, the profit margin variable (Adjpm), the profit margin on loss firms (Losspm), the expected growth variable (Adjgro), and R&D
expenditures (R&D), all play a much more important role for these firms.18
Table 8 reports the PB regression for technology firms. The average adjusted r -square for these firms of 52.6% compares favorably with the adjusted
r -square for the full sample of 51.2% (see table 4). The best year had an
adjusted r -square of 71.2% and the worst year had an adjusted r -square of
35.3%. Lev, Adjgro, Adjpm, Losspm, and Rd all play more important roles in
this sample than in the full sample. Taken together, these results suggest
that the eight explanatory variables are effective in explaining variations in
the PB ratios even among new economy stocks.

18 To be consistent with the overall sample, we report results using industries defined in terms
of two-digit SIC codes. The results using three-digit SIC codes (not reported) are marginally
stronger.

430

S. BHOJRAJ AND C. M. C. LEE


TABLE 7
Annual Estimation of Warranted Enterprise-Value-to-Sales for Technology Firms

This table year-by-year estimation regression results for the following regression:
EVSi,t = at +

8


j,t C j,i,t + i,t

j =1

Only firms in the technology, biotechnology, and telecommunication sectors are included in
the sample. The independent variable, EVS, is the enterprise-value-to-sales ratio as of June 30th
of each year. The eight explanatory variables are as follows: Indevs is the industry harmonic mean
of EVS based on two-digit SIC codes; Indpb is the industry harmonic mean of the price-to-book
ratio; Adjpm is the difference between the firms profit margin and the industry profit margin,
where profit margin is defined as operating profit divided by sales; Losspm is adjpm indicator
variable, where the indicator variable is 1 if profit margin 0 and 0 otherwise; Adjgro is the
difference between the analysts consensus forecast of the firms long-term growth rate and the
industry average; Lev is long-term debt scaled by book equity; Rnoa is operating profit as a
percent of net operating assets; and Rd is R&D expense as a percentage of sales. P -values are
provided in parentheses. The last rows represents the time series average coefficients along with
Newey- West autocorrelation corrected t-statistics. The adjusted r -square (r -sq) and number of
firms (# obs) are also reported.
Year Intercept
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
All

0.0746
(0.694)
1.8275
(0.00)
0.3207
(0.191)
0.4148
(0.00)
0.6893
(0.00)
0.2585
(0.248)
0.3333
(0.071)
0.4446
(0.077)
0.0290
(0.901)
0.3252
(0.068)
0.2295
(0.116)
0.1469
(0.484)
0.4518
(0.004)
1.3244
(0.00)
0.0339
(0.911)
0.1878
(0.583)
0.4906
(0.103)
0.1496
(0.385)

Indevs

Indpb

2.5147
(0.00)
1.3958
(0.00)
1.3194
(0.00)
0.9490
(0.00)
0.9863
(0.00)
0.6142
(0.15)
0.8095
(0.00)
1.8429
(0.00)
2.5311
(0.00)
1.4312
(0.00)
0.4087
(0.058)
0.8104
(0.003)
0.6072
(0.00)
0.6868
(0.003)
0.5914
(0.007)
0.7185
(0.00)
0.3496
(0.142)

0.7345
(0.054)
0.6604
(0.03)
0.0248
(0.90)
0.2765
(0.002)
0.2137
(0.35)
0.3837
(0.03)
0.1195
(0.039)
0.1766
(0.11)
0.7448
(0.045)
0.0199
(0.845)
0.4255
(0.011)
0.0694
(0.581)
0.0902
(0.261)
0.1303
(0.447)
0.2069
(0.249)
0.3130
(0.056)
0.5722
(0.001)

Adjpm

Losspm

8.6017

(0.00)
13.6505

(0.00)
10.4726 2.1075
(0.00)
(0.36)
8.6284 6.2307
(0.00)
(0.013)
6.8203 6.1216
(0.00)
(0.00)
10.7332 6.9660
(0.00)
(0.002)
9.2366 5.5708
(0.00)
(0.001)
8.8866 8.2629
(0.00)
(0.00)
10.5869 5.3715
(0.00)
(0.006)
12.5785 5.5412
(0.00)
(0.005)
10.1490 6.3325
(0.00)
(0.00)
13.0156 6.3610
(0.00)
(0.019)
12.2570 8.5298
(0.00)
(0.00)
15.4918 8.6079
(0.00)
(0.004)
10.1740 9.6489
(0.00)
(0.00)
12.930010.9113
(0.00)
(0.00)
13.326313.8360
(0.00)
(0.00)

Adjgro

Lev

Rnoa

Rd

0.0365
(0.00)
0.0984
(0.00)
0.0537
(0.00)
0.0419
(0.00)
0.0354
(0.00)
0.0878
(0.00)
0.0752
(0.00)
0.0418
(0.00)
0.0483
(0.00)
0.0402
(0.00)
0.0689
(0.00)
0.0908
(0.00)
0.0340
(0.00)
0.1054
(0.00)
0.1174
(0.00)
0.0870
(0.00)
0.1340
(0.00)

0.1998
(0.11)
0.3145
(0.226)
0.0420
(0.794)
0.1008
(0.088)
0.2603
(0.007)
0.2573
(0.081)
0.0649
(0.508)
0.1172
(0.148)
0.0934
(0.193)
0.1464
(0.207)
0.0977
(0.199)
0.0130
(0.879)
0.0012
(0.99)
0.1448
(0.38)
0.1133
(0.387)
0.1287
(0.053)
0.1851
(0.168)

0.0104
(0.077)
0.0226
(0.006)
0.0259
(0.00)
0.0017
(0.575)
0.0021
(0.698)
0.0024
(0.778)
0.0088
(0.107)
0.0003
(0.951)
0.0107
(0.07)
0.0226
(0.00)
0.0112
(0.113)
0.0007
(0.906)
0.0034
(0.42)
0.0108
(0.114)
0.0140
(0.008)
0.0064
(0.216)
0.0092
(0.182)

0.0379
(0.001)
0.0705
(0.00)
0.0286
(0.27)
0.0494
(0.00)
0.0619
(0.00)
0.0449
(0.004)
0.0435
(0.00)
0.0268
(0.008)
0.0515
(0.00)
0.0179
(0.081)
0.0031
(0.733)
0.0550
(0.00)
0.0249
(0.002)
0.0663
(0.00)
0.0521
(0.00)
0.0355
(0.001)
0.0393
(0.001)

R-sq # Obs
78.70

84

78.13

88

73.74

98

84.92

118

70.17

125

64.98

143

69.48

134

75.64

131

71.38

130

72.15

152

68.15

168

64.55

173

70.39

185

65.21

213

63.07

261

62.83

286

58.85

290

1.0922 0.0105 11.0317 7.3600 0.0704 0.0657 0.0061 0.0417 70.14 2779
(0.00) (0.928) (0.00)
(0.00) (0.00) (0.086) (0.09) (0.00)

WHO IS MY PEER?

431

TABLE 8
Annual Estimation of Warranted Price-to-Book for Technology Firms
This table provides yearwise coefficients from the following regression:
PBi,t = at +

8


j,t C j,i,t + i,t

j =1

Only firms in the technology, biotechnology, and telecommunication sectors are included in
the sample. The independent variable, PB is the price-to-book ratio as of June 30th of each year.
The eight explanatory variables are as follows: Indevs is the industry harmonic mean of EVS
based on two-digit SIC codes; Indpb is the industry harmonic mean of the price-to-book ratio;
Adjpm is the difference between the firms profit margin and the industry profit margin, where
profit margin is defined as operating profit divided by sales; Losspm is adjpm indicator variable,
where the indicator variable is 1 if profit margin 0 and 0 otherwise; Adjgro is the difference
between the analysts consensus forecast of the firms long-term growth rate and the industry
average; Lev is long-term debt scaled by book equity; Roe is net income before extraordinary
items scaled by common equity; and Rd is R&D expense as a percentage of sales. P -values are
provided in parentheses. The last rows represents the time series average coefficients along with
Newey- West autocorrelation corrected t-statistics. The adjusted r -square (r -sq) and number of
firms (# obs) are also repoted.
Year Intercept
1982 0.3719
(0.521)
1983
1.0815
(0.195)
1984
0.8739
(0.064)
1985 0.6571
(0.05)
1986 0.5377
(0.221)
1987
0.1112
(0.796)
1988
0.3808
(0.388)
1989 0.7627
(0.204)
1990 1.5790
(0.002)
1991 0.3213
(0.365)
1992 0.4658
(0.195)
1993
0.9354
(0.123)
1994
0.2271
(0.74)
1995
0.9133
(0.415)
1996
0.0096
(0.988)
1997 1.1275
(0.115)
1998 0.9291
(0.076)
All

Indevs

Indpb

0.2384
(0.845)
1.4809
(0.051)
0.8572
(0.074)
0.1940
(0.668)
1.0501
(0.165)
0.4919
(0.531)
0.3979
(0.546)
1.0294
(0.312)
0.4220
(0.48)
0.5554
(0.197)
1.3092
(0.008)
0.2871
(0.691)
0.4288
(0.403)
0.6040
(0.198)
0.3468
(0.299)
0.4317
(0.354)
0.8094
(0.037)

0.3554
(0.68)
0.2848
(0.564)
0.0138
(0.972)
0.8856
(0.01)
1.5479
(0.003)
0.8625
(0.077)
0.7731
(0.128)
1.5381
(0.036)
1.6713
(0.00)
0.8374
(0.013)
1.8016
(0.00)
0.7052
(0.172)
1.0209
(0.047)
0.6983
(0.201)
1.0941
(0.00)
1.5256
(0.00)
1.8563
(0.00)

Adjpm

Losspm

2.4541

(0.168)
1.9356

(0.604)
6.4148 0.8036
(0.00)
(0.91)
5.1695 9.7264
(0.00)
(0.016)
4.6753 6.5886
(0.03)
(0.017)
4.502215.3127
(0.077) (0.001)
2.8966 9.1768
(0.14)
(0.001)
6.200525.9330
(0.001) (0.00)
3.737417.0171
(0.048) (0.00)
6.7005 9.1000
(0.00)
(0.005)
6.266810.3212
(0.019) (0.023)
6.089118.4597
(0.011) (0.002)
8.0718 7.2491
(0.00)
(0.018)
8.174017.0127
(0.00)
(0.019)
6.3722 5.7468
(0.002) (0.218)
4.917710.6854
(0.022) (0.001)
6.3907 8.3244
(0.006) (0.019)

Adjgro

Lev

Roe

0.0725
(0.00)
0.1713
(0.00)
0.0915
(0.00)
0.0597
(0.00)
0.0375
(0.039)
0.1294
(0.00)
0.1100
(0.00)
0.0809
(0.00)
0.0894
(0.00)
0.0467
(0.001)
0.1516
(0.00)
0.1503
(0.00)
0.0769
(0.00)
0.1720
(0.00)
0.1487
(0.00)
0.1473
(0.00)
0.2128
(0.00)

0.1017
(0.64)
0.6545
(0.178)
0.1966
(0.36)
0.2904
(0.113)
0.2447
(0.415)
0.4758
(0.01)
0.3173
(0.017)
0.0533
(0.728)
0.1774
(0.354)
0.1309
(0.454)
1.3935
(0.00)
0.1518
(0.583)
0.7869
(0.001)
0.5063
(0.071)
0.6142
(0.039)
0.6558
(0.007)
1.0429
(0.00)

0.0727
(0.00)
0.1242
(0.00)
0.0277
(0.066)
0.0683
(0.00)
0.0362
(0.023)
0.0966
(0.00)
0.0776
(0.00)
0.0681
(0.00)
0.0848
(0.00)
0.0445
(0.00)
0.0355
(0.002)
0.0640
(0.00)
0.0180
(0.033)
0.0735
(0.00)
0.0580
(0.00)
0.1190
(0.00)
0.0676
(0.00)

Rd

R-sq # Obs

0.0936 71.24
(0.00)
0.1876 57.22
(0.00)
0.0265 59.03
(0.177)
0.0375 62.75
(0.012)
0.0439 47.50
(0.039)
0.0280 53.02
(0.277)
0.0269 58.17
(0.0142)
0.0054 60.01
(0.736)
0.0256 60.99
(0.173)
0.0211 54.38
(0.231)
0.0036 52.53
(0.881)
0.0169 42.93
(0.43)
0.0530 42.59
(0.001)
0.0885 44.25
(0.00)
0.0411 35.31
(0.068)
0.0092 44.02
(0.633)
0.0268 47.93
(0.163)

84
87
102
121
124
141
138
138
138
158
169
177
196
220
164
294
301

0.1306 0.4490 1.0278 5.351111.3234 0.1146 0.3980 0.0668 0.0397 52.58 2752
(0.554) (0.001) (0.00) (0.00)
(0.00) (0.00) (0.001) (0.00) (0.009)

432

S. BHOJRAJ AND C. M. C. LEE

Table 9 reports the forecasting regression results for technology firms.


Panel A shows that using the industry harmonic mean alone (IEVS) results
in 13.4% to 16.4% in adjusted r -squares. Adding size-matched comparable firms improves the results marginally, to between 14.5% and 16.8%.
However, the predictive power of the model does not increase substantially
until we include comparable firms selected on the basis of warranted multiples. Adding the four nearest comparable firms matched on WEVS (COMP)
almost triples the r -square in the current year, and more than doubles the
r-square for all the other years. Adding WEVS increases the adjusted r -square
by a further 5 to 10%. Panel B shows that the adjusted r-squares are again
lower for the PB ratio. However, the incremental contribution of WPB and
either COMP or ICOMP remains sharp. Evidently the warranted multiples
approach is effective in controlling for differences in profitability, growth,
and risk that affect the EVS and PB ratios of new economy stocks. In fact, the
incremental usefulness of this approach seems to be even more pronounced
in the sub-sample of new economy firms than in the full-sample.

6. Summary
Our goal in this paper is to develop a more systematic technique for selecting comparable firms. Our approach selects comparable firms on the basis
of profitability, growth, and risk characteristics that theory suggests should
be cross-sectional drivers of a particular valuation multiple. Specifically, we
use regression analysis and large sample estimation techniques to generate
a warranted multiple for each firm. The comparable firms are those firms
whose warranted multiple is closest to that of the target firm.
We test our approach by examining the efficacy of the selected comparable
firms in predicting future (one- to three-year-ahead) enterprise-value-tosales and price-to-book ratios. Our tests encompass the general universe of
stocks as well as a sub-population of new economy stocks from the tech,
biotech, and telecommunication sectors. Our results show that comparable
firms selected in this manner offer sharp improvements over comparable
firms selected on the basis of other techniques, including industry and size
matches. The improvement is most pronounced among the so-called new
economy stocks.
These findings suggest a number of possible extensions and applications.
The technique we outline here is not limited to the EVS or PB multiple. It
is straightforward to extend the analysis to other multiples such as priceto-cash-flows or price-to-earnings (both forward and historical). Some of
the theoretical work for this type of extension has already been done; others are still being developed.19 Indeed, it might be desirable to combine
the results from several different multiples to come up with a set of firms
that are close peers based on alternative estimation procedures. We believe this composite approach will enhance the precision and objectivity of
19 Ohlson and Nuettner-Nauroth [2000] is a good example, in which the price-to-forwardearnings ratio is explicitly modeled.

TABLE 9
Prediction Regressions for Technology Firms
This table provides average estimated coefficients from the following prediction regressions:
EVSi,t+k = at +

n


j,t C j,i,t + i,t

PBi,t+k = at +

j =1

n


j,t C j,i,t + i,t

j =1

where k = 0, 1, 2, 3. Only firms in the technology, biotechnology, and telecommunication sectors are included in the sample. In Panel A, the dependent
variable is the enterprise-value-to-sales ratio (EVS). In Panel B, the dependent variable is the price-to-book ratio (PB). The expanatory variables are: IEVS, the
harmonic mean of the industry EVS based on current year (k = 0), but excluding the target firm; ISEVS, the harmonic mean of the actual EVS for the four closest
firms matched on size after controlling for industry; WEVS, the firms warranted EVS, determined using the coefficients derived from last years estimation
regressions and current year accounting and market-based variables; COMP, the harmonic mean of the actual EVS for the four closest firms matched on WEVS;
and ICOMP, the harmonic mean of the actual EVS for the four closest firms matched on WEVS after controlling for industry. The variables for Panel B are
defined analogously, replacing EVS with PB. Table values represent the time-series average of the coefficients from annual cross-sectional regressions. The
bottom row reports the average adjusted r -square of the annual regressions.
Panel A: Enterprise-value-to-sales
Current year EVS

0.26 0.11 0.13


0.28 0.02 0.10
0.05 0.03 0.05
0.77 0.07
1.03 0.71
0.33
13.91 14.42 35.65 45.50 46.73

0.80
1.24

6.91

0.65
1.00
0.09

One year ahead PB


0.73 0.37 0.13
0.92 0.46 0.15
0.31 0.29 0.28
0.51 0.09
0.69

0.26
0.05
0.28

0.51
0.31
8.43 15.41 19.59 21.45

Three year ahead EVS

0.06 0.08 0.03


0.48 0.25 0.24
0.06 0.06 0.04
0.73 0.04
0.92 0.58
0.32
13.89 14.31 31.62 39.00 39.72
0.46
1.24

0.61
1.34

7.09

0.47
1.16
0.07

Two year ahead PB


0.57 0.23 0.04
1.02 0.66 0.48
0.29 0.28 0.28
0.41 0.05
0.51

0.23
0.33
0.28

0.31
0.32
7.73 11.40 13.35 13.98

0.42
1.32

0.42
1.27
0.05

16.35

16.82

0.49
1.46

8.65

0.00 0.09 0.04


0.63
0.37
0.36
0.06
0.06
0.05
0.70
0.01
0.84
0.58
0.28
31.21 36.71 37.27

Three year ahead PB


0.35
0.02
0.04
1.00
0.73
0.66
0.46
0.45
0.45
0.35
0.31
0.08
10.24

12.77

14.88

0.12
0.55
0.47
0.05
0.37
14.90

433

Panel B: Book-value-to-sales
Current year PB
Inter
0.90 0.82 0.29 0.17 0.24
IPB
1.19 1.02 0.30 0.09 0.14
ISPB
0.17 0.13 0.09 0.08
COMP
0.80 0.25
WPB
0.87 0.92
ICOMP
0.21
r -sq
8.80 9.65 28.27 36.70 37.93

0.64
1.10

Two year ahead EVS

WHO IS MY PEER?

Inter
0.71 0.72 0.28 0.16 0.16
IEVS
1.07 0.99 0.05 0.29 0.32
ISEVS
0.06 0.03 0.00 0.02
COMP
0.97 0.08
WEVS
1.11 0.83
ICOMP
0.39
r -sq
13.39 14.45 45.88 56.38 58.23

One year ahead EVS

434

S. BHOJRAJ AND C. M. C. LEE

multiples-based valuation methods, and bring much needed discipline to


equity valuation.
Financial analysts and valuation experts often operate under conflicting
incentives.20 If a more objective and conceptually defensible technique for
selecting comparable firms becomes widely accepted, the onus will be on
an analyst to justify the selection of firms that depart significantly from the
norm. Our point is that any normative approach to selecting comparable
firms should reflect the fundamental concepts that underpin equity valuation. We do not regard our model as in any sense optimal. However,
we believe that an industry-based approach with firm-specific adjustments
is a sensible first attempt at empirically capturing these some key concepts
from valuation theory. Future work might consider variables that capture
the quality of earnings or other value relevant attributes not considered in
this study.
These results seem to have further potential for development as a decision
aid for financial analysis and investors. Experimental evidence suggests that
analysts may focus on more salient firms within an industry when selecting
comparables. As in the case of Guidant Inc. (Appendix C), it is likely that
our approach will nominate suitable peer firms that do not come immediately to mind to an analyst. A main advantage of market multiples is their
convenience in common practice, particularly in valuing private firms. It is
therefore important that any tool developed from this research be relatively
easy to use. The technique outlined here is fairly simple to implement.
The procedure would involve estimating warranted EVS and PB ratios (or
warranted price-to-earnings and other ratios) for a population of currently
traded firms. After firms have been ranked by the warranted multiple, the
names of comparable firms for any given target firm can be readily retrieved.
In fact, one can envision a web-based tool that returns a set of warranted
multiples, and a list of comparable firms, for each ticker entered. The idea
is to retain the convenience of the valuation heuristic while improving its
precision and objectivity. A simple version of this tool, updated weekly, is
now available on our web site (http://parkercenter.johnson.cornell.edu).
From an application point of view, the contribution of this methodology
is most evident when pricing non-traded firms, or when identifying a set of
comparable control firms. For publicly traded firms, we find that a company
is its own best peeri.e., a companys own lagged multiple is best at explaining its current multiple. However, it is not possible to secure lagged multiples
for private firms. Nor are lagged multiples useful in identifying control firms
for research purposes. In these latter applications, the warranted multiple
methodology offers some important advantages.
Our approach has at least three implications for academic researchers.
First, we provide a new research design device for isolating a variable of
interest. Barber and Lyon [1997], Lyon et al. [1999], and others suggest that
long-window tests of abnormal returns are more powerful when samples are
20

For a recent discussion of these problems from the popular press, see Morgenson [2000].

WHO IS MY PEER?

435

matched on the basis of firm characteristics, such as size and the book-tomarket ratio. Our study extends this line of research by suggesting a more
precise technique for identifying match firms. By controlling for general
determinants of market valuation, we introduce a research design device
that helps to isolate the pricing effect of other specific variables of interest
to the researcher. This research design should be broadly applicable in
studies that examine specific research issues (e.g., pooling versus purchase
accounting, or quality of earnings considerations).
Second, we introduce a parsimonious valuation methodology, which is
conceptually consistent with a noisy rational expectation equilibrium framework. Most past studies either assume market efficiency (price is the best
benchmark for value), or ignore it (value firms without reference to price).
In a philosophical departure, we treat price as a noisy, but informative, signal for firm valuation. In this framework, the current price is not necessarily
the best proxy for the true (unobserved) intrinsic value. However, it is likely
that price contains information useful for valuation purposes. Our approach
harnesses the information in price without relying on it entirely. This approach is in the spirit of the market-based valuation research advocated by
Lee [2001].
Finally, these results suggest additional tests of market efficiency. To the
extent that stock prices sometimes deviate from intrinsic value, it is possible
that a firms warranted multiple could contain information useful in forecasting future returns. Specifically, one can envision trading strategies based
on the deviation between warranted and actual multiples. Certainly the improved precision with which future EVS and PB ratios can be forecasted is
suggestive of such a strategy. This would appear to be another interesting
venue for further research.
APPENDIX A
Descriptive Statistics on Profit and Loss Firms
This appendix provides descriptive statistics on profit versus loss firms as of 5/29/2000. The
sample of 3,515 firms represent all NYSE/AMEX/Nasdaq stocks (excluding ADRs) with a
market capitalization of $100 million or more and at least 12 months of price and fundamental
data. Loss firms are defined as those with negative income before extraordinary items over
most recent four fiscal quarters.
Panel A: What percentage of these firms have a positive
Num

N.I.?

Gross
EBIT? Op. Inc.? EBITDA? Margin? Sales?

FY1?

Book
Value?

Profit firms

2739 100% 100%


98%
100%
100% 100% 100% 99%
(78%)
Loss firms
776
0%
25%
40%
47%
87%
100% 34%
94%
(22%)
Panel B: Distribution of realized returns over the past six months (10/30/99 to 5/29/00)
Num

Mean Std. Dev. 10th %tile 25th %tile Median 75th %tile 90th %tile

Profit firms 2739


7.8% 42.3%
(78%)
Loss firms
776 19.6% 111.3%
(22%)

30.3%

15.6%

+1.3%

+21.1%

+52.5%

56.6%

34.4%

2.3%

+43.6%

+105.7%

436

S. BHOJRAJ AND C. M. C. LEE

APPENDIX B
Variable Descriptions
All accounting and forecasted variables are based on the most recent information available
as of June 30th of each year. Stock prices are as of the end of June. Compustat data item is
reported in parentheses.
Variable

Description

EVSt

Enterprise Value to Sales

PBt

Price to Book

Indevs

Industry EVS ratio

Indpb

Industry PB ratio

Adjpm

Industry adjusted profit margin

Losspm

Adjpm Indicator variable

Adjgro

Industry adjusted long-term


analyst growth forecast

Lev

Leverage

Rnoa

Return on net operating assets

Roe

Return on equity

R&D

Research and development


expenditures

Calculation
EVS = (Market value of equity +
Long-term debt (D9) + debt in
current liabilities (D34))/Net
Sales (D12). EVSt is the
t-year-ahead EV-to-sales ratio.
PB = Market value of equity/Total
common equity (D60). PBt is the
t-year-ahead price-to-book ratio.
Harmonic mean of the EVS ratio for
firms in the industry (based on
2-digit SIC code).
Harmonic mean of the PB ratio for
firms in the industry (based on
2-digit SIC code).
Firm profit marginmedian
industry profit margin; where
profit margin is operating profit
after depreciation (D178)/Net
Sales (D12).
Adjpm Indicator variable; where
Indicator Variable =1 if firm profit
margin is less or equal to 0, and 0
otherwise.
Consensus analyst forecast of
long-term growth for the firm
from IBESmedian consensus
analyst forecast in the industry.
Total long term debt (D9)/Total
stockholders equity (D216).
(Operating Income after
depreciation (D178)/(Net
property plant and equipment
(D8) + Total current assets
(D4) Total current liabilities
(D5))) 100.
Net Income before extraordinary
items (D18)/Common equity
(D60) 100.
Research and development expenses
(D46)/Net Sales (D12).

APPENDIX C
Guidant Corp.: A Case Study
This appendix illustrates the set of firms in same two-digit SIC code that are closest to Guidant Corp., based on warranted enterprise-value-to-sales
(EVS) and on warranted price-to-book (WPB). The warranted multiples are computed using regression coefficients estimated as of April 30, 2001.
Firms are ranked by WEVS (WPB). Warranted price is the price based on the WEVS/WPB and % mispricing is (Actual Price-Warranted price)/Actual
Price. Ind is the two-digit SIC code for the industry.
WPB

Warranted
Price (EVS)

Warranted
Price (PB)

%
Mispricing

%
Mispricing

Panel A: Six Closest Peers by WEVS


SBSE
38
SBS TECHNOLOGIES INC
MDCC
38
MOLECULAR DEVICES CORP
KLAC
38
KLA-TENCOR CORP
GDT
38
GUIDANT CORP
TWAV
38
THERMA WAVE INC
MDT
38
MEDTRONIC INC
SRTI
38
SUNRISE TELECOM INC

3.633
3.638
3.650
3.748
3.823
3.888
4.188

3.90
3.76
4.46
5.20
4.24
5.06
4.48

40.5
25.0
41.9
28.3
29.7
17.4
9.5

33.34
38.29
45.59
19.95
23.54
22.45
9.47

107.50
28.53
17.51
14.23
67.98
61.83
6.87

70.70
96.77
10.28
39.55
32.98
50.88
6.93

Panel B: Six Closest Peers by WPB


CMOS
38
CREDENCE SYSTEMS CORP
MDT
38
MEDTRONIC INC
IMA
38
INVERNESS MEDICAL TECHN
GDT
38
GUIDANT CORP
BEC
38
BECKMAN COULTER INC
CYTC
38
CYTYC CORP
CTI
38
CHART INDUSTRIES INC

4.756
3.888
5.007
3.748
2.001
5.251
1.853

5.00
5.06
5.08
5.20
5.24
5.38
5.92

63.5
17.4
25.7
28.3
47.8
6.5
13.7

70.07
22.45
21.15
19.95
30.18
7.00
13.33

178.12
61.83
22.29
14.23
28.90
70.26
320.78

206.65
50.88
35.99
39.55
18.64
68.12
310.31

Ind

Name

WHO IS MY PEER?

WEVS

Ticker

437

438

S. BHOJRAJ AND C. M. C. LEE


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