Acomparablefirmisonewithcashflows,growthpotential,
andrisksimilartothefirmbeingvalued.Itwouldbeidealif
wecouldvalueafirmbylookingathowanexactlyidentical
firm—in termsofrisk, growth, andcash flows—is priced.
Nowhereinthisdefinitionisthereacomponentthatrelatesto
the industry or sector to which a firm belongs. Thus, a
telecommunicationsfirmcanbecomparedtoasoftwarefirm,
ifthetwoareidenticalintermsofcashflows,growth,and
risk.Inmostanalyses,however,analystsdefinecomparable
firmstobeotherfirmsinthefirm’sbusinessorbusinesses.If
thereareenoughfirmsintheindustrytoallowforit,thislist
isprunedfurtherusingothercriteria;forinstance,onlyfirms
ofsimilarsizemaybeconsidered.Theimplicitassumption
beingmadehereisthatfirmsinthesamesectorhavesimilar
risk, growth, and cash flow profilesand therefore can be
compared with much more legitimacy.
Thisapproachbecomesmoredifficulttoapplywhenthereare
relativelyfewfirmsinasector.Inmostmarketsoutsidethe
United States, the number of publicly traded firms in a
particularsector,especiallyifitisdefinednarrowly,issmall.
It is also difficult to define firms in the same sector as
comparablefirmsifdifferencesinrisk,growth,andcashflow
profilesacrossfirmswithinasectorarelarge.Thus,thereare
hundredsofcomputersoftwarecompanieslistedintheUnited
States,butthedifferencesacrossthesefirmsarealso large.
Thetrade-offisthereforeasimpleone.Defininganindustry
morebroadlyincreasesthenumberofcomparablefirms,but
it also results in a more diverse group of companies.
Therearealternativestotheconventionalpracticeofdefining
comparablefirms.Oneistolookforfirmsthataresimilarin
termsofvaluationfundamentals.Forinstance,toestimatethe