AN INVESTIGATION OF A MULTIVARIATE SIMILARITY APPROACH FOR PEER SELECTION IN RELATIVE VALUATION

Abstract

This study presents a multivariate similarity-based peers approach (MSBP) for the selection of peer firms in relative valuation. We select peer firms based on the collective similarity of ten variables which reflect firms’ expected profitability, risk and growth. We test this approach by comparing its valuation accuracy relative to the industry membership selection method. We measure accuracy based on the absolute percentage pricing error and the squared percentage pricing error. We conclude that selecting comparable firms based on our approach offers very sharp improvements in the accuracy of relative valuation using the price-to-book, enterprise-value-to sales and price-to-earnings ratios in comparison to the industry membership selection method. Also, we introduce the use of a multivariate similarity visualization tool which we believe will be very useful in finance research, in general, and firm valuation research in particular.
JEL Classification: G320.