Adjustments to Comps – Special Situations
A target company or comparable often faces special situations. In such cases, adjustments need to be made to certain metrics and/or the equity or enterprise value. Adjustments to comps are often required for a variety of different reasons. Major adjustments are necessary if there are major inconsistencies, as enumerated below.
The most common adjustments to comps are:
- LTM (last twelve months)
- Exceptional items
- Convertible debt
- Mezzanine finance
- Market value of debt and/or preference shares
- Associates and Joint Ventures
- Pro forma: disposal, acquisition
Currency does not affect multiples because exchanges rates will affect the denominator and the numerator. But, of course, for financial analysis, always use the share price traded on the primary exchange.
Generally, financials should be adjusted for:
- Different year-ends
- Seasonality of business
- Growing/declining activity
For example, to annualize to December a company with a March financial year-end:
Alternatively, the annualization can be done using quarterly or monthly accounts if these are available.
Last twelve months (LTM)
This is one of the most common adjustments to comps that analysts have to perform. Last twelve months (LTM) numbers are used where the profits of the comparable businesses are growing (or declining) significantly and/or are seasonal. In such situations, annualizing numbers may be an over-simplification of the profits and may not be indicative of the companies’ most recent trading performances.
Exceptional and extraordinary items are characterized by:
- Unusual nature (unrelated to ordinary business activities)
- Infrequency of occurrence
There is variability in classifying exceptional/extraordinary items. Additionally, companies would prefer losses and charges to be classified as exceptional so that underlying profits, for example, valuation metrics, are unaffected by such news. Exceptional/extraordinary items may include:
- Restructuring charges
- Profits and losses on disposals
- Financing one-offs (e.g., debt redemption above book value)
- A share in unconsolidated affiliates’ exceptional items
True exceptional and extraordinary items should be stripped out. If adjusting net income (for equity level comps), refer to the tax notes in the accounts to find the tax effect of exceptionals. If not available, use the effective/marginal tax rate. However, not all exceptional/extraordinary items have a tax effect. Additionally, the tax effect of like items will be different in different countries due to differing tax laws.
Associates and joint ventures
Earnings from associates/joint ventures are not always directly comparable. For example, income from associates is reported in the US as a share of profit after tax. In the UK, it is reported as per associates but with additional disclosure about the sales of the joint venture. When material, associates and JVs should either be:
- Consolidated in proportion (including debt); or
- Excluded and valued on a separate basis.
When not material, associates and JVs are included in EBIT.
Consolidate in proportion (including debt)
This method is used if:
- A joint venture is proportionally consolidated (i.e., the pro forma numbers are already presented in the consolidated accounts); and/or
- The associate/JV has similar activities and growth prospects so that it is appropriate to apply the same multiples to both parts of the business
Exclude and value on a separate basis
The market values a company’s equity value to include that of the associate/JV whereas the P&L metrics do not include the associate/joint venture. If two companies have different activities or growth prospects, the resulting metrics are not appropriate for all parts of the business. This is appropriate if the associate/JV has different activities or growth prospects relative to its owner.
Enterprise value is measured at the market value of all its components. Minorities are a part of enterprise value and should also be valued at market value. Otherwise, they should be included at book value. There may be problems if the subsidiary in which the minority arises is unquoted. Unquoted minorities will have to be valued on a separate basis.
Consistency of metrics
Where comparable businesses finance their operational assets can significantly impact profit metrics. For example, the comparability of EBIT or even EBITDA of airline companies is limited, and EBITDAR should be the metric of choice when comparing the underlying trading performances of the business.
Alternatively, the operating leases could be converted (mathematically) into finance leases. (Though this may not necessarily be relevant due to IFRS 16).
If EBITDAR is the metric of choice (or the adjusted EBITDA), then EV / EBITDAR should be the multiple. However, EBITDAR (by definition, before rentals, depreciation and interest) is independent of the method of finance of the asset. Where the asset has been acquired outright or has been finance-leased, the net debt (a component of EV) has been increased while the operating lease obligation remains off-balance sheet.
For consistency between EV and EBITDAR, operating leases should be converted into finance leases, by calculating the present value of the minimum lease commitments. A schedule of payments and the appropriate discount rate are needed to do this – neither of which is likely to be presented in financial statements.
- The longer the lease terms, the higher the present value of the lease payments.
- The lower the discount rate, the higher the present value of the lease payments.
For example, if a company’s corporate borrowing rate is assumed to be the applicable rate for refinancing the operating leases, the present value of these commitments will be higher than if the WACC was used. Additionally, as the leases end, they may need to be replaced and so the lease terms may be indefinite.
Unfunded pension obligations
If a business guarantees a minimum pension to employees on retirement, it must make payments into the pension scheme to meet these future obligations. These payments will be invested with the intention of meeting the future pension requirements. As time moves on, employees within the scheme will be getting closer to pensionable age and may also be entitled to greater pension payouts as they continue to work for the business. It is possible to calculate the pension deficit as the difference between the market value of scheme assets and the present value of liabilities to scheme members. If a business has not made sufficient payments to the pension scheme, the scheme is likely to be in deficit. Comparable companies that have made sufficient cash payments into the scheme (no deficit) will consequently have different net debts than companies with deficits.
Accounting issues for adjustments to Comps
The accounting rules followed for defined benefit pensions schemes vary significantly:
Adjusting net debt
The net pension scheme deficit is unlikely to be recognized on the balance sheet. However, when using either US GAAP, UK GAAP, or IFRS, this figure is disclosed in the accounts and so international comparability can be achieved. Since payments into pension schemes are tax deductible, any payments made to reduce this deficit will reduce taxes payable.
As with the accounting (or non-accounting) in the balance sheet, internationally the income statement effects will vary. Once more, US GAAP, UK GAAP, and IFRS disclose similar figures. Where EBIT or EBITDA is the metric of choice, the most relevant element is the current service cost – being the increase in the projected benefit obligation (present value of scheme liabilities) due to employees working for the company during the period. To calculate EBIT or EBITDA, the existing accounting for pensions in the income statement should be removed and replaced with the current service cost (as an operating expense).
Keys to success
Here are some important things to consider when making accounting adjustments to Comps:
- Understand the industry by reading analyst reports and news stories
- Select comparable companies carefully – more is not necessarily better.
- Use the most recently published financials.
- Only use the most appropriate broker.
- All source documentation should be marked to show where information has been extracted from with both a Post-it showing the page and a highlighter showing the numbers used
- Use footnotes.
- Always reconcile the broker historicals with the published historicals – this will help to understand how the broker has defined key metrics, e.g., EBIT and EPS, so that the historicals and the forecasts can be input using the same adjustments.
- Ensure that the numbers are comparable – potentially, the more adjustments made for special situations.
- Keep the comps analysis up to date.
- Check your work.
- Understand the results of the analysis and be prepared to discuss them.
Learn how to build a Comps table from scratch in CFIs Business Valuation Modeling Course.
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