Comparable Company Searches Aren’t Just for Transfer Pricing
Jun 27, 2014
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In transfer pricing, the Comparable Profits Method (“CPM”) is frequently used to identify an arm’s length range. Indeed, this is the most commonly used method in the IRS Advance Pricing and Mutual Agreement Program and it has become part of the standard transfer pricing toolkit for many multinational companies. However, the general approach used when applying the CPM is not purely a creation of tax authorities. Rather, the approach of valuation by comparison to comparables is also commonly used in finance and real estate.
In finance, valuing a company by reference to other similar companies is often referred to as “relative valuation.” For example, when a new company issues publicly-traded stock for the first time (i.e., an “initial public offering” or “IPO”), there is no existing market for the stock that can be used as a benchmark price. (Analogously, in transfer pricing parlance, there is no direct comparable uncontrolled price). As a result, a different valuation method is needed to provide an indication of the price for the new securities. Absent an active market for the new securities, investment bankers often look at how the financial markets value other similar companies in a relative value framework.
A key step in applying the relative value framework is to identify a set of companies that are sufficiently similar to the company in question (i.e., a search for comparable companies). Similar companies are likely to be found in the same general industry and will perform similar functions, employ similar assets, and bear similar risks. For example, one could choose companies in the same geography with similar size, growth potential, and credit risk rating. For the valuation, key competitors whose stock is publicly traded could be useful.
Once a set of comparable companies is chosen as a benchmark, the investment bank then must choose an appropriate multiple. A multiple is a relevant indicator that is observed for both the company whose stock is being valued and the comparator companies (akin to a profit level indicator, or PLI in transfer pricing). Like a PLI, the multiple should be a measure that is relevant to the business activities of the company. For example, in transfer pricing one might use an operating profit margin to measure the arm’s length return for a sales function. Similarly, the appropriate multiple for a retail business might be a price to sales ratio since sales are an important indicator for a retail company. The multiples for the comparator companies are then used to derive the value for the IPO.
As this discussion demonstrates, the CPM was not created out of whole cloth by tax authorities. Rather, in transfer pricing as in finance, the best method to value a transaction or a business will depend, in part, on the available data. Absent comparable prices or transactions, experts in both fields may rely on searches for comparable companies and careful analysis of the companies identified.