How to do a Comparable Company Analysis
Originally published: 13/12/2017 14:08
Publication number: ELQ-42157-1
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How to do a Comparable Company Analysis

A guide on how to valuate a company by using the comparable company method.

Introduction

In this chapter we will cover five key topics:

1) Comparable Company Analysis (aka “Comps”) Overview
2) Peer Universe
3) Market Capitalization & Enterprise Value
4) Historical & Projected Financials
5) Spread Multiples

  • Step n°1 |

    Comparable Company Analyses (Comps) Overview

    WHAT ARE COMPS?


    Comparably Company Analyses, or “Comps”, are a relative valuation technique used to value a company by comparing that company’s valuation multiples to those of its peers. Typically, the multiples are a ratio of some valuation metric (such as equity Market Capitalization or Enterprise Value) to some financial performance metric (such as Earnings/Earnings Per Share (EPS), Sales, or EBITDA). (An astute reader will note that Sales and EBITDA are enterprise-wide metrics, and thus should be used with Enterprise Value, while Earnings/EPS is an equity-related metric, and thus should be used with Market Capitalization.) The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal.


    WHY USE COMPS?


    Comps are relatively easy to perform, and the data for them is usually relatively widely available (provided that the comparable companies are publicly traded). Additionally, assuming that the market is efficiently pricing the securities of other companies, Comps should provide a reasonable valuation range, while other valuation methods such as DCF are dependent upon an entire array of assumptions.
    These factors make Comps one of the most widely-used valuation techniques in practice. Investment bankers, sell-side research analysts, private equity investors, and other market analysts all use Comps. They do have their disadvantages, however.

    How to do a Comparable Company Analysis image
  • Step n°2 |

    Performing a Comparable Companies Analysis

    REMEMBER C.V.S.


    When doing a Comps analysis, a useful checklist of things to do has a mnemonic that is easy to remember: “C.V.S.”


    > Confirm relevant peer universe.
    > Validate key fundamental metrics.
    > Select appropriate multiple for valuation.


    The appropriate selection of a relevant peer universe is critical for a Comps analysis, because it plays a significant role in the valuation of the target company. For example, a company could sometimes be compared across two different industries due to the nature of the business (e.g. an internet retail company). Similarly, some comparable companies might need to be ruled out or adjusted because it owns businesses across several different industry groups. Peer universe selection is therefore somewhat subjective.


    When doing a Comps valuation, the analyst can choose to use either trailing (historical) performance metrics, or future (forecast) performance metrics. (Note that many analyses will look at both historical and future metrics.) In general future metrics are preferred, but one needs to be careful with this. For example, projected EBITDA and projected Earnings/EPS are subject to all kinds of potential pitfalls associated with forecasting. The forecast numbers may end up being significantly off.


    Additionally, when performing a Comps analysis you may want to adjust the performance for various one-time charges and non-recurring items (such as a sale of assets, a one-time legal expense, or a restructuring charge). It is important that all companies in the analysis use “clean” numbers to provide an “apples-to-apples” comparison. This becomes especially difficult when using future performance metrics, as the non-recurring items may be as-yet unknown.


    KEY ASSUMPTIONS & PROJECTIONS:


    To quickly recap on key assumptions and projections that we need to make when performing a Comps analysis:
    > Peer Universe: A selection of competitor/similar companies used to determine a benchmark valuation.
    > EBITDA: Historical & projected Earnings before Interest, Taxes, Depreciation & Amortization.
    > EPS: Historical & projected Earnings Per Share.


    TYPES OF MULTIPLES


    There are various types of multiples that can be used in a Comps analysis. In general, multiples can be classified in two broad categories: Operating multiples and Equity multiples. Operating multiples refer to the operating results of the business as a whole while Equity multiples refer to the value created from the company that is available to equity/shareholders.


    Typical multiples for Comps include:
    > EV/Sales: The Enterprise value of the company divided by Sales/Revenue (Operating multiple)
    >EV/EBITDA: The Enterprise value of the company divided by EBITDA (Operating multiple)
    >P/E: Price/Earnings ratio for a company (Equity multiple). This is either calculated as Share Price ÷ EPS, or Market Capitalization ÷ Earnings (they are mathematically equivalent).
    >P/B: Price/Book ratio for a company (Equity multiple). This is either calculated as Share Price ÷ Book Value per Share, or Market Capitalization ÷ Shareholders’ Equity (they are mathematically equivalent).
    >P/(Levered) Cash Flow: Price/Cash Flow ratio for a company (Equity multiple). This is either calculated as Share Price ÷ Levered Cash Flow per Share, or Market Capitalization ÷ Levered Cash Flow (they are mathematically equivalent).


    Note that for Operating Multiples we use Enterprise Value as the numerator of the calculation, while for Equity Multiples, we use Market Capitalization as the numerator. You should generally not use EV for equity-related performance metrics, nor should you use Market Capitalization for enterprise-related performance metrics.


    RECAP ON OPERATING MULTIPLES:
    The most commonly used Operating multiples are EV/Sales and EV/EBITDA.
    Operating multiples ignore financial leverage (Debt) and typically ignore Depreciation & Amortization.
    They value the total company versus common stock (Equity) only.
    They are frequently used by investment bankers, private equity investors.


    RECAP ON EQUITY MULTIPLES:
    The most commonly used Equity multiples are P/E, P/B, and P/Cash Flow (Levered).
    Equity multiples ignore cash flow to Debt holders.
    They are frequently used by investment bankers and equity analysts.
    In this training course, the two most common multiples, EV/EBITDA (an Operating multiple) and P/E (an Equity multiple), will be used. However, it is still worthwhile to be aware of other kinds of multiples, as they are frequently used.


    WHEN ARE PRICE/SALES MULTIPLES USED?
    Price/Sales multiples are typically used for companies with negative, highly volatile, or abnormally high/low EPS. For example, fast-growing companies that have no earnings yet or negative earnings (because they are spending a lot of money to grow or have not yet reached critical mass for sales) may be valued based upon multiples of Sales. A common advantage of using Price/Sales is the general stability and lower accounting distortion afforded by sales numbers. However, sales numbers can be manipulated through revenue recognition practices and growth companies can be given high valuations regardless of having no earnings or cash flow. Additionally, using Sales as a basis for valuation does not take into account the profitability of those Sales figures. Some companies, for example, may be able to turn a large profit margin on incremental sales, while others might have very narrow profit margins.


    WHEN ARE PRICE/BOOK MULTIPLES USED?
    Price/Book multiples are often used to value financial services companies since their balance sheets are primarily composed of liquid assets that often approximate market values. These multiples can also be used for companies with no earnings, highly variable earnings or companies not expected to continue as a going concern. Unfortunately, for most companies in most industries the Price/Book ratio is highly idiosyncratic, because the Book Value is a function of all past business activities (literally since the company’s founding or most recent recapitalization). Therefore Price/Book ratios can swing wildly depending on each company’s circumstances.


    WHAT ARE CASH FLOW MULTIPLES?
    Cash Flow multiples use an estimate of Cash Flow, such as EBITDA, Operating Cash Flow, Free Cash Flow, and Levered Free Cash Flow, as a valuation indicator. These multiples are often superior to Earnings multiples because they ignore a lot of the idiosyncrasies of accrual-based accounting and are therefore less subject to management manipulation. (Note that EBITDA ignores Capital Expenditures, which are indeed a Cash outflow. Thus in many instances Comps will use (EBITDA – Capital Expenditures) as the Cash Flow estimate.)


    Many times in practice, the reciprocal of these multiples are used to produce Cash Flow Yields, which are compared against treasury yields and dividend yields as a valuation yardstick.


    PITFALLS TO AVOID WHEN USING COMPS
    Avoid these typical pitfalls when building a Comps analysis:
    > Inappropriate peer universe selected
    > One-off and recurring items included in historical/projected EBITDA and EPS
    > Wrong multiple selected for valuation


    Again, remember the mnemonic, “C.V.S.”
    > Confirm relevant peer universe.
    > Validate key fundamental metrics.
    > Select appropriate multiple for valuation.


    STEPS TO REMEMBER FOR EXECUTING A COMPS VALUATION


    1) Select a Peer Universe: Pick a group of competitor/similar companies with comparable industries and fundamental characteristics.
    2) Calculate Market Capitalization: It is equal to Share price × Number of Shares Outstanding.
    3) Calculate Enterprise Value: Market Capitalization + Debt + Preferred Stock + Minority Interest (less common) – Cash.
    4) Historical & Projected Financials: Use historical financials from filings and projections from management, sell-side equity analysts, etc.
    5) Spread Multiples: Using Market Capitalization, Enterprise Value and historical/projected financials, spread (i.e., calculate) EV/EBITDA and P/E multiples.
    6) Value Target Company: Pick the appropriate benchmark valuation multiple for the peer group, and value the target company based on that multiple. Typically, an average or median is used.


    SOURCES OF INFORMATION NEEDED FOR COMPS


    > Peer Universe: Company filings, Research Reports, Bloomberg, or FactSet
    > Historical Financial Results: SEC.gov has company annual reports (10-K), Quarterly reports (10-Q), and (where available) investor Prospectuses.
    > Financial Projections: Management estimates, sell-side equity analyst estimates, and/or internal estimates generated by the bank

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