Criteria Used for Selecting Comparable Firms

Cross-sectional analysis advocates comparison of information or data of "similar" firms. But in reality the selection of "comparable or similar firms" is not an easy task. The following are some of the variables that can be used as yardstick for selecting "similar" entities:

1. Similarity on Supply Side: Firms may be grouped on the basis of having similar raw materials, similar production processes, similar distribution networks, and so on. For example, the International standard for industrial classification classifies industries on the basis of "physical or technological structure" and "similarity of products". In India , a similar classification is undertaken by the Indian Statistical Organization (ISO), which classifies the whole enterprises into one, two, three and four digit industries. A one and two digit classification is the broadest classification of an industry while a four digit classification is the narrowest classification. For example, a mutual fund company is given a broad group code of 651 (financial intermediation), a class code of 6599 and a sub-class code of 65991. Companies which fall under the same group classifications can be selected for cross-sectional purposes.

2. Similarity on the Demand Side: Under this classification, companies producing similar products can be compared. The comparison can have a short run perspective or a long run perspective. For example, the financial statements of Godrej and Hindustan Lever Limited can be compared as they share common line of products like soaps, toiletries, hair care, household care and fabric care.

3. Similarity in Capital Market Attributes: This classification takes the investor's view point in grouping firms. Firms can be grouped on the basis of attributes such as risk, price-earnings ratios, or market capitalization. For example, in case of Indian investor, he can choose between A, B, B1 or Z category stock classification given by Securities and Exchange Board of India. For analysis purpose, two or more companies of any one of these categories can be selected.

4. Similarity in Legal Ownership: An important method of ascertaining comparable firms is on the basis of ownership. Financial statements of different subsidiaries of a company may be compared. These subsidiaries may be quite diverse in terms of both supply-side and demand-side characteristics. Their similarity arises from being owned by the same set of shareholders.

In some cross-sectional analysis applications, more than one set of variables may be used for selecting comparable firms.

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