One of the three major valuation methodologies employed by investment bankers is trading comparables analysis. In the world of corporate finance, there are two forms of valuation that are utilized in comparables analysis – relative valuation and fundamental valuation. Each method comes with its own advantages and disadvantages.
With comparables analysis, we are assessing a company’s value relative to its publicly traded peers. The main advantage of this method is speed. It is much faster to apply the average peer group’s multiple to your company’s financial metric than it is to forecast each year’s cash flows. However, no two companies are exactly alike, and certain companies may be trading at a premium or discount to the rest of the peer group for unique reasons. Conversely, the company that we are trying to value may command a premium or discount to the rest of the peer group for its own unique set of circumstances that form its competitive advantage. Therefore, the nuance to comparable valuation is less about the calculation than it is about appropriate selection.
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While no two companies are identical, the objective of comparable company analysis is to find as many close peers as possible to create averages for the multiples to be used in valuing your client company. Ideally, the peer group should be similar in terms of enterprise value, revenue, and cash flows, as well as the industry-specific operations that generate economic benefits. Embedded in a company’s enterprise value are three important considerations when choosing a peer set – liquidity, leverage, and earnings.
As discussed previously, liquidity concerns a company’s sources and uses of cash and all else equal, a company with a stronger liquidity profile should trade at a premium to its peers. The company’s current cash position is subtracted from its debt and equity to arrive at enterprise value. Secondly, the company’s debts outstanding must be compared as well. Too much leverage in a company’s capital structure poses a greater risk compared to an all-equity company and should trade at a discount to its peers, all else being equal.
Lastly, the market value of equity reflects earnings expectations, and a company with stronger and more sustainable earnings should (again) trade at a premium to its peers, all else being equal. Comparing each of these elements with the peer groups’ business operations creates a stronger basis for selecting peers for comparable valuation.
Another helpful tool to utilize when selecting a peer group involves choosing industry peers with similar ROIC. This metric is a standardized measure of competitive advantage as it relates to a company’s expected runway for growth. When paired with careful company analysis, the resulting peer set will be a far more robust one to extrapolate a client company’s valuation. In essence, companies with superior products, better access to customers, recurring revenues, or benefit from economic moats will likely post stronger ROICs that manifest through premium trading multiples.
As discussed previously, different industries adhere to different sets of multiples on which their companies are assessed. The three most common multiples that are relevant to most industries are EV/Sales, EV/EBITDA, and P/E. For both enterprise value multiples, we are comparing the top-line and operating margins across the peer group. For P/E, we are comparing only the market value of equity with the amount available to a company’s shareholders across the peer group.
Generally speaking, all companies seek to maximize shareholder value, and the general way that they achieve this is by growing their revenues while expanding their margins. Hence, these three multiples are often at the core of multiple selections. However, certain industries use multiples that are more specific to the nature of their businesses. For example, we may see multiples such as EV/Daily Production in the oil and gas industry, or EV/Subscribers for internet businesses.
Furthermore, when choosing multiples, it is important to compare how historical and forward capital streams are being valued today. We can identify this trend using trailing and forward multiples at current equity valuations across a peer set. For example, if a company is expected to experience improved profitability in the future relative to peers, a company might trade at a more premium forward EBITDA multiple than a less profitable peer. Historical multiples are limited in usefulness as past performance may not be indicative of future performance, but comparing trailing multiples against a peer set may reveal performance trends over time, and how market expectations may have changed for a company.
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