IB Manual – Adjusting Comps
Special circumstances in comparable company analysis
Special circumstances in comparable company analysis
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:
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:
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.
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:
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:
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.
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:
When not material, associates and JVs are included in EBIT.
This method is used if:
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.
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.
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.
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.
The accounting rules followed for defined benefit pensions schemes vary significantly:
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).
Here are some important things to consider when making accounting adjustments to Comps:
Learn how to build a Comps table from scratch in CFIs Business Valuation Modeling Course.
Thank you for reading this section of CFI’s free investment banking book on special situations in comparable company analysis and how to make adjustments to Comps. To keep learning and advancing your career, the following resources will be helpful: