Comparable Company Approach03/09/2022 0 By indiafreenotes
The main purpose of equity valuation is to estimate a value for a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case and equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day.
There are a number of different methods of value a company with one of the primary ways being the comparable (or comparables) approach. Before we explore what this valuation method entails, let’s compare it to other valuation methods.
Comparable company analysis starts with establishing a peer group consisting of similar companies of similar size in the same industry or region. Investors are then able to compare a particular company to its competitors on a relative basis. This information can be used to determine a company’s enterprise value (EV) and to calculate other ratios used to compare a company to those in its peer group.
Steps in Performing Comparable Company Analysis
- Find the right comparable companies
This is the first and probably the hardest (or most subjective) step in performing a ratio analysis of public companies. The very first thing an analyst should do is look up the company you are trying to value on CapIQ or Bloomberg so you can get a detailed description and industry classification of the business.
The next step is to search either of those databases for companies that operate in the same industry and that have similar characteristics. The closer the match, the better.
The analyst will run a screen based on criteria that include:
- Industry classification
- Size (revenue, assets, employees)
- Growth rate
- Margins and profitability
- Gather financial information
Once you’ve found the list of companies that you feel are most relevant to the company you’re trying to value it’s time to gather their financial information.
Once again, you will probably be working with Bloomberg Terminal or Capital IQ and you can easily use either of them to import financial information directly into Excel.
The information you need will vary widely by industry and the company’s stage in the business lifecycle. For mature businesses, you will look at metrics like EBITDA and EPS, but for earlier stage companies you may look at Gross Profit or Revenue.
If you don’t have access to an expensive tool like Bloomberg or Capital IQ you can manually gather this information from annual and quarterly reports, but it will be much more time-consuming.
- Set up the comps table
In Excel, you now need to create a table that lists all the relevant information about the companies you’re going to analyze.
The main information in comparable company analysis includes:
- Company name
- Share price
- Market capitalization
- Net debt
- Enterprise value
- Analyst estimates
- Calculate the comparable ratios
With a combination of historical financials and analyst estimates populated in the comps table, it’s time to start calculating the various ratios that will be used to value the company in question.
The main ratios included in a comparable company analysis are:
- EV/Gross Profit
Relative vs. Comparable Company Analysis
There are many ways to value a company. The most common approaches are based on cash flows and relative performance compared to peers. Models that are based on cash, such as the discounted cash flow (DCF) model, can help analysts calculate an intrinsic value based on future cash flows. This value is then compared to the actual market value. If the intrinsic value is higher than the market value, the stock is undervalued. If the intrinsic value is lower than the market value, the stock is overvalued.
In addition to intrinsic valuation, analysts like to confirm cash flow valuation with relative comparisons, and these relative comparisons allow the analyst to develop an industry benchmark or average.
The most common valuation measures used in comparable company analysis are enterprise value to sales (EV/S), price to earnings (P/E), price to book (P/B), and price to sales (P/S). If the company’s valuation ratio is higher than the peer average, the company is overvalued. If the valuation ratio is lower than the peer average, the company is undervalued. Used together, intrinsic and relative valuation models provide a ballpark measure of valuation that can be used to help analysts gauge the true value of a company.
Valuation and Transaction Metrics Used in Comps
Comps can also be based on transaction multiples. Transactions are recent acquisitions in the same industry. Analysts compare multiples based on the purchase price of the company rather than the stock. If all companies in a particular industry are selling for an average of 1.5 times market value or 10 times earnings, it gives the analyst a way to use the same number to back into the value of a peer company based on these benchmarks.
How to read about company:
- This includes Company Name, Ticker, and Price. The ticker is a unique symbol given to the company to identify publicly listed companies.
- You may take Bloomberg, Reuter’s tickers as well. Also, note that the prices that we take here are the most recent prices.
- We make the table so that these prices are linked to the database, where they would get updated automatically.
Size of the company:
- This includes Market Capitalization and Enterprise Value.
- We normally sort the table based on Market Capitalization. Market Capitalization also provides us pseudo for the size of the company.
- Enterprise Value is the current Market-based valuation of the firm.
- We may not want to compare a small market capitalization company with a large one.
- It should include 2 to 3 appropriate valuation tools for comparison
- We should ideally show one year of historical multiple and two years of forwarding multiples (estimated)
- Choosing an appropriate valuation tool is the key to successfully valuing the company.
- Operating Metrics
- It may include fundamental ratios like Revenue, growth, ROE, etc
- It is important to understand the fundamentals of the company at once.
- To make this comp more meaningful, you may include Profit Margins, ROE, Net Margin, Leverage, etc.
- It is a simple mean, median, low, and high of the above metrics
- Mean, and Median provides core insights to the fair valuation
- If a company’s multiple is above the mean/median, we tend to infer that the company may be overvalued
- Likewise, if the multiple is below the mean/median, we may infer that it is undervalued.
- High and Low also help us understand the outliers and a case to remove those if they are too far away from the Mean/Median.