Valuation Part 1: Comparable Companies Analysis

Comparable companies analysis ("comparable companies" or "trading comps") is one of the primary methodologies used for valuing a given company, division, business, or collection of assets. It provides a benchmark against which a banker can establish valuation for a private company or analyze the value of a public company at a given point in time. Comparable companies has a broad range of applications, most notably for various mergers & acquisitions situations, initial public offerings, restructurings, and investment decisions.

The foundation for trading comps is built upon the premise that similar companies provide a highly relevant reference point for valuing a given target due to the fact that they share key business and financial characteristics, performance drivers, and risks. Therefore, the investor can establish valuation parameters for the target by determining its relative positioning among peer companies.
(Source: Investment Banking, Pearl & Rosenbaum)

We do this by determining key financial ratios and multiples of the comparable companies, spreading the comps on a spreadsheet for analysis, choosing median multiples, and then using these multiples to project a valuation for the target company. 

Examples of the multiples we might use are Enterprise Value/Earnings before Interest, Taxes, Depreciation, and Amortization. (EV/EBITDA); EV/EBIT; Price/Earnings; Price/Book Value; etc. 

The multiples we would use could change depending on the industry of the companies we are evaluating. For example, a financial institution (bank) could have a negative enterprise value, in which case we would use P/E or P/BV instead.

Steps to Comparable Companies Analysis:
1. Select the Universe of Comparable Companies
2. Locate the Necessary Financial Information
3. Spread Key Statistics, Ratios, and Trading Multiples
4. Benchmark the Comparable Companies
5. Determine Valuation

Step 1: Select the Universe of Comparable Companies

You want to select companies that are comparable to the target company you are trying to analyze. Things to consider when selecting comparable companies are:
BUSINESS PROFILE                                                   FINANCIAL PROFILE
-Business Sector                                                             -Size (market cap.)
-Products and Services                                                   -Profitability (profit margins)
-Geography                                                                     -Growth Profile (growth rates)
-Customers                                                                      -Return on Investment (return on equity, etc.)

For example, if you are doing a comparable companies analysis on Starbucks, you may want to look at Peet's Coffee or Green Mountain Coffee Roasters because they are in the same sector, offer the similar products, and cater to the same customers. By doing your own due diligence you should be able to find out whether or not they share similar market capitalization, profitability, growth rates, and ROI. But where do you find the financial information necessary to calculate ROI, profitability, growth profiles, Enterprise Value, EBITDA, etc.?

Step 2: Locate the Necessary Financial Information

You will be able to find the necessary financial information from a combination of sources. Often one source alone will not be enough, you will need to utilize information gathered form multiple sources.

-SEC Filings: 10-k, 10-q, 8-k, and proxy statements.
-Equity Research Reports
-Financial News Reports
-Financial Data Sites (Bloomberg, Morningstar, Yahoo Finance)

Once you have the data, you will need to compile it and calculate the financial ratios necessary to analyze our comparable companies.

Step 3: Spread Key Statistics, Ratios, and Trading Multiples

Key Statistics and Ratios include: equity value, enterprise value, sales, gross profit, EBITDA, EBIT, net income, net income margins, historical and estimated growth rates, return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and dividend yield.

Due to a lack of time, I will not go over how to calculate these items here. Information regarding how to calculate them is available online. A simple google search will certainly point you in the right direction. Investopedia is a reliable source for information.

Key Trading Multiples include: P/E, Equity Value/ Net Income, Enterprise Value/ EBITDA, Enterprise Value/ EBIT, and Enterprise Value/sales.

Once you've calculated the ratios and multiples for the comparable companies, you will lay them out on a spreadsheet for easy viewing. The next step is to benchmark the comparable companies.

Step 4: Benchmark the Comparable Companies

Benchmarking is used to identify which financial data you have spread is most relative to the company you are valuing. This will usually involve honing in on a few companies that share particularly similar financial data to the target company, and sort of disregarding the outliers.

In benchmarking, you will want to compare the financial statistics and ratios of the comparable companies to the target company. For example, if the target has a net income margin of 10% and a few of the comparable companies have net income margins of 9-11%, you will want to focus on these companies. Obviously these comparisons should be completed for the rest of the financial stats and ratios as well.

Then, you want to benchmark the trading multiples. Ideally, those with similar financial statistics and ratios will also be those with similar trading multiples to the target company. Once you've determined which companies are most comparable to the target, you will set a range on key multiples which you will use for the final part, valuation.

Part 5: Determine Valuation

Imagine you have 3 closest comparable companies, which you will call B, C, and D. The target is A. For determining valuation, you will want to look at the trading multiples, as these will give you something with which to project a valuation for the target. For this, I am going to reference the Enterprise Value (EV)/EBITDA multiple. Imagine the 3 closest comparables EV/EBITDA ranges from 13.5-14.5X EBITDA. You can calculate the mean, median, high and low if you would like. For now, let's just use the mean, and assume it is 14X EBITDA.

Also assuming that company A's EBITDA for the last twelve months (LTM) is $100M, the projected Enterprise Value for company A, using a 14X EBITDA multiple, will be $1.4 billion.

Enterprise Value= Equity Value + Debt + Minority Interest + Preferred Stock - Cash.

In order to get to a per share value, we need to get from enterprise value to equity value. Assuming no minority interest or preferred stock, and $100M in net debt, we have an equity value of $1.3 billion.

Equity Value/ # Fully Diluted shares = price per share.

Assuming there are 100 million fully diluted shares for company A...

$1.3 billion/100 million = $13/share.

And there you have it, a very rough and simplified description of how you perform Comparable Companies Analysis to value a company.

*Much of the information given here has been sourced from Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions by Rosenbaum and Pearl. It is an excellent book that goes into great detail on Valuation, LBOs, and M&A.  If you're interested in finance, investing, and specifically Investment Banking, I'd highly recommend having a look at it.*

Here is a visual depiction of a comparable comps analysis. It is not related to the numbers I've described above, but it does help elucidate some of the confusing topics we've talked about.

I hope this was informative, educational, and has inspired you to want to go out there and value a company of your own. Look out for "Valuation, Part 2: Precedent Transactions Analysis" coming sometime soon.

Cheers,
BFB


P.S.- If this was horribly confusing, but you are interested in understanding it, please comment and I'd enjoy helping you out.