Learning Outcomes
After reading this article, you will be able to explain the process of selecting comparable companies for relative valuation, identify when financial adjustments (normalisation) are essential, and describe common pitfalls when preparing ratios for methods such as price/earnings (P/E) and earnings yield. You will learn how accurate selection and adjustment of comparables influence the reliability of business valuation results for ACCA Financial Management.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand how to apply relative valuation models in company valuations. Focus your revision on:
- Identifying and selecting appropriate comparable companies for market-based valuation techniques
- Understanding the effect of differences in size, industry, or financial structure on comparability
- Making necessary adjustments (normalisation) to published figures for fair comparison
- Applying P/E ratio and earnings yield valuation models using adjusted data
- Recognising the impact of non-operating and one-off items on valuation multiples
- Discussing the practical limitations and potential errors in relative valuation
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Why is it important to normalise a company's earnings before applying P/E ratios for valuation?
- Which characteristic is least relevant when choosing a comparable company?
a) Similar industry
b) Similar size
c) Different accounting policies without adjustment
d) Comparable risk profile - True or false? Non-recurring gains should always be removed when calculating normalized earnings for valuation.
- Explain one adjustment you might need to make to the financial statements of a peer company to improve comparability for relative valuation purposes.
Introduction
Relative valuation uses the observed prices of similar companies as a basis for estimating the value of a business. This approach is only as reliable as the quality of the comparables chosen and the suitability of the adjustments made to the financial data. In professional practice and in ACCA FM exams, relative valuation requires you to select appropriate peers and “normalise” their earnings, removing items that are not representative of future performance. This article outlines the key steps and exam techniques for choosing and adjusting comparables for methods such as the P/E ratio and earnings yield.
Key Term: relative valuation
The process of estimating a company’s value by reference to the market values and valuation ratios of similar businesses, with necessary adjustments for comparability.
Selecting Appropriate Comparables
The accuracy of any relative valuation depends on how closely the comparables match the target business.
Criteria for Selecting Comparables
- Industry and Sector: Choose companies from the same or closely related fields, as they face similar risks and growth prospects.
- Size and Scale: Align company size, as larger companies may trade on different multiples than smaller ones.
- Geographical Market: Ideally, select businesses operating in similar economic and regulatory environments.
- Business Model: Ensure comparables share the same core activities and sources of revenue.
- Financial Structure: Differences in financing, especially gearing, can significantly affect ratios and returns.
Key Term: comparables
Companies selected for relative valuation because they share key operational, industry, or financial characteristics with the subject business.
When to Exclude a Company
Avoid comparables that:
- Operate in entirely different industries or markets
- Are affected by significant recent one-off events (e.g., major restructuring)
- Exhibit unstable or unusual accounting practices compared to the target company
- Are illiquid, thinly traded, or have unreliable financial disclosure
Normalising Financial Information
Simply using reported profits often leads to misleading results. Normalisation is the process of adjusting reported data to reflect core, recurring, and sustainable earnings.
Key Term: normalising (in valuation)
Making systematic adjustments to a company’s financial statements to remove one-off, non-recurring, or non-operating items, aiming to present a more accurate measure of ongoing financial performance.Key Term: non-recurring items
Transactions or events that are unusual, infrequent, or unlikely to repeat, such as major asset sales, exceptional legal costs, or restructuring expenses.
Why Normalisation Matters
Valuation ratios like P/E are only meaningful if based on future maintainable earnings. Non-recurring gains or losses can artificially inflate or deflate key ratios, resulting in unreliable valuations.
Common Normalising Adjustments
- Remove one-off gains or losses: Exclude profits or charges from events not expected to recur, such as asset disposals, insurance settlements, or redundancy programs.
- Adjust for discontinued operations: Strip out results of segments the company has exited or sold.
- Align accounting policies: If comparables use different depreciation methods or inventory valuation systems, restate earnings for consistency.
- Exclude non-operating items: Remove income or expenses not related to the core business, e.g., investment returns not linked to operations.
- Ensure period alignment: Match financial years and reporting periods where possible.
How to Apply Adjustments
Start with reported profit. Use the notes to accounts to identify and adjust for non-recurring or non-operating items. The resulting "normalised profit" forms the basis for your valuation multiples.
Worked Example 1.1
A company’s reported profit is $40m. The profit includes a one-off $8m gain from the sale of land and $3m in non-recurring redundancy costs. What is the normalised profit for valuation?
Answer:
Exclude the $8m gain and add back the $3m expense:$40m – $8m + $3m = $35m. Use $35m as normalised profit for P/E calculations.
Worked Example 1.2
A peer company uses accelerated depreciation, leading to annual charges of $6m, while the target company uses straight-line depreciation leading to $4m annual charges. Adjust normalised profit for comparability.
Answer:
Recalculate the peer’s profit as if using straight-line depreciation:
Add back the $2m excess depreciation ($6m – $4m) to reported profit.
Exam Warning
When performing P/E or earnings yield valuation, always remove any non-recurring items and ensure accounting consistency. Relying on unadjusted profits may result in significant valuation errors and is a common exam pitfall.
Summary
In relative valuation, careful selection and normalisation are essential for reliable exam answers and real-world application. Only truly comparable companies—matched for size, industry, risk, and accounting policies—should be included. Remove one-off, exceptional, and non-operating items to ensure multiples reflect sustainable earnings. State any adjustments you make in your valuation workings for full marks.
Key Point Checklist
This article has covered the following key knowledge points:
- The criteria for selecting comparable companies in relative valuation
- When and how to normalise (adjust) financial information for comparable analysis
- Typical types of adjustments: removing non-recurring or non-operating items and aligning accounting policies
- The critical importance of using normalised, not reported, earnings in methods like P/E ratio or earnings yield
- Common mistakes if comparables are poorly chosen or not properly adjusted
Key Terms and Concepts
- relative valuation
- comparables
- normalising (in valuation)
- non-recurring items