273: M4 - Comparable Analysis Flashcards
Comparable Analysis Approach
The premise of this approach is to determine the value of an asset based on the observed price in the market of a very similar asset. This approach works really well if the asset being valued is reasonably common and is similar to other companies in the market place. Ex. RBC and TD
Dividend Discount Model Approach
This approach is highly similar to the approach we used to value bonds, where the value of an asset is the time discounted value of all future cash flows. In the case of a stock, we are finding the time discounted value of all future dividend payments as opposed to coupon payments in the example of a bond. This approach works really well for stocks that pay consistent dividends and are mature and stable. The problem with this approach is that not all firms pay dividends and the model captures the growth potential of the firm only indirectly via the potential for dividends to grow.
Discounted Cash Flow Approach (DCF)
This approach typically receives the most weight in the overall valuation. The DCF model calculates the present value of a company’s forecasted, unlevered free cash flows. The advantage to this model is it can be applied universally to all companies but has the downside of being highly sensitive to the assumptions made during forecasting.
What does an analyst look for in comparions?
- Comparison firms that have similar future prospects
- No fundamental differences between firms (same industry, same supply chain, same customers)
- Same growth rates
- Same cost of capital (discount rate)
- Industry (or comparison set) is correctly valued
How do we compensate for this since the assumptions are almost universally violated? – Rations allow us to standardize firms to the same comparable scale
4 steps to a comparable company analysis
- Select the comparable company set
- Collect data
- Select and calculate appropriate valuation ratios
- Calculate ratio statistics and value
Elaboration on step 1 of the comparable company analysis
The first step in the comparable company analysis is creating the list of comparable companies that are as representative of the company being valued as possible. Recall that the objective is to find comparables that have the same future prospects that are fundamentally the same with consistent growth rates. Goal is to have a group of 4-8 comparable companies
Law of One Price
the “Law of One Price” which states that identical assets will have the same price regardless of where they are traded. This is from an academic perspective to justify the use of comparable to value an equity security
Comparable companies for a valuation are usually found in …
Usually found within the same sub-industry. Goal is to have a group of 4-8 comparable companies
What is a key consideration when building a peer group?
The key consideration when creating a peer group is identifying companies with as similar as possible cash flows. Typically, a good approach is to start at the broad industrial classification and then select the companies that are most representative with operations in the same region. However, companies with similar cash flows from different industries may be better comparables.
Factors to focus on when creating a peer group
Industry classification
Size
Geography
Growth Rate
Profitability
Captial Structure
Price/Earnings Ratio definition, issues, strengths
The Price/Earnings ratio is one of the most common valuation ratio’s used to aid the analyst in determining a value for a target company.
The numerator in all valuation ratio’s (in this case the share price) represents what the investor is paying.
The denominator (in this case earnings) represents what the investor is getting in return.
The earnings denominator can get controversial as they can be historical (LY, TTM, FY) or a forecast into the future (NTM)
Challenges: The metric is meaningless for a company with little to no earnings or even negative earnings. Also, there are numerous issues related to a company’s reported earnings. Management has the ability to impact the reported earnings as a result of discretionary accounting decisions, does not take capital structure (risk) into consideration
Price/Book
The Price/Book metric measures how much an investor is willing to pay for each dollar of book value.
Some of the advantages of using this metric are that book value is usually positive and generally it is a stable number. This metric is commonly used for comparing financial firms as the assets and liabilities of a financial firm are well represented by book value.
There are drawbacks that limit the use of this metric. Book value does not do a good job of capturing the value of non-physical assets such as patents, trademarks, intellectual property, goodwill, etc. Book value also becomes less relevant as physical assets age. Accounting policies and share repurchases also have an impact on the relationship between market value and book value. This metric is never used when analyzing technology based firms.
Loss-making companies can’t be valued using current P/E and will often also have negative cash flows. P/BV, which is based on book value representing cumulative earnings and paid-up capital, is a method that can be used for companies with negative earnings.
Price/Sales Metric
The Price/Sales metric measures what an investor is willing to pay for each dollar of sales a company is able to generate.
Unlike earnings, sales are always a positive number. Also, from an accounting perspective , it is very difficult for a company to manipulate the reported sales figure. The Price/Sales metric is generally a stable metric and is commonly used to compare technology based companies which have yet to mature to the point where earnings have become reliable and consistent.
Price/Cash Flow
The Price/Cash Flow metric measures what an investor is willing to pay for each dollar of cash flow a company is able to generate.
This metric is consistent with the idea that the value of any asset is equal to the present value of future cash flows.
One of the main issues related to this metric is determining the definition of cash flow.
Some main issues associated with using price-based valuation metrics
one of the main issues associated with using price-based valuation metrics is that they fail to consider the company’s capital structure and therefore the risk level associated with a given company. The solution to this problem has been the movement towards enterprise value-based metrics.
