Topic 7: Valuation Based on Comparable Firms Flashcards
What is the method of comparables (or relative) valuation?
The method of comparables uses the value of other similar firms to estimate the value of a given firm instead of valuing the firm’s cash flows directly.
It requires a valuation multiple, such as the P/E ratio, to adjust for changes in scale across firms.
How is the valuation multiple computed?
Valuation multiples are computed by using an average or weighted average of comparable firms’ multiples. This average multiple is then multiplied by the denominator relevant to the subject firm (e.g., earnings, revenue) to imply the numerator (e.g., firm value) of that subject firm.
What are the advantages of using relative valuation?
Simplicity: Requires few assumptions and judgment calls, making it quick and easy to apply.
Sensitivity to Market Conditions: Results reflect the impact of current market conditions, such as financial crises or liquidity issues, as they are baked into the prices.
What are the disadvantages of using relative valuation?
The Bandwagon Problem: Would you be willing to pay $1M for a “magic mirror” on the wall just because everyone else is?
The Bystander Effect: Has anyone actually done a valuation based on fundamentals?
Lack of True Comparables: Would you expect Walmart & Target to have the same comparables?
Lack of Appropriate Multiples: How do you value a company with no revenue, earnings, or primarily intangible assets?
What are four examples of use cases for relative valuation?
Private Companies
Short-term or Momentum Trading
Volatile Market Conditions
The Stockbroker
What is the first proposition about relative valuation?
In relative valuation, all that you are concluding is that a stock is under or overvalued relative to the comparable group.
A stock can be relatively cheap and yet hopelessly overvalued at the same time.
What is intrinsic valuation?
Intrinsic valuation is the true, underlying value of an asset based on fundamentals such as Free Cash Flows (FCFs), growth potential, and risk.
Future cash flows expected from an asset are projected and then discounted back to the present value using a discount rate that reflects the asset’s risks.
Calculated using DCF
What factors should be considered when choosing between comparables in valuation?
- Similar Operating Business Model
Geography (e.g., regulatory environment, customer base, etc.)
Size (e.g., revenue, headcount, locations, etc.)
Strategy (e.g., pricing, margins, volume, branding, etc.)
Life-stage (e.g., growth firm or mature company)
- Capital Structure & Payout Policy (depending on the multiple)
Equity or debt financing
What are the general rules for choosing between multiples in valuation?
The multiple must be consistently defined.
The multiple must be uniformly estimated.
What are Trailing Multiples?
Use historical measure in the denominator
Ex: Trailing P/E is based on historical earnings. Usually EPS over the prior 12 months, LTM
Data is available on filing
What are Forward Multiples?
Use forward measures in the denominator
Ex: Forward P/E is based on forward earnings. Usually expected EPS over the next 12 months, NTM
Data is based on analysts’ forecasts or internal estimation
Assume you are comparing P/E ratios across technology companies, many of which have options outstanding. What measure of P/E ratio would yield the most consistent comparison?
A. Price/Primary EPS (actual shares, no options)
B. Price/Fully Diluted Shares (actual shares + all options)
C. Price/Partially Diluted Shares (counting only ITM - in the money options)
D. Other
Other: Use EV/EBITDA as it provides a more comprehensive value of the company (market cap, debt, and cash) and is independent of capital structure.
What are the three possible ways to proceed when choosing between multiples?
Use a simple average of valuations obtained with a variety of multiples.
Use a weighted average of the valuations obtained using a variety of multiples.
Choose only one of the multiples.
Common Multiple for Manufacturing Sector
P/E
Share Price/EPS
EPS = Net income/# of outstanding shares
- Often with normalized earnings
Common Multiple for Profitable Growth Firms
PEG ratio
= P/E/Annualized EPS Growth
Differences in growth rates primarily drive deviations in value
Common Multiple for Young growth firms with losses
Revenue Multiples
Don’t have another choice
Common Multiple for Infrastructure
EV/EBITDA
Early losses due to depreciation
Common Multiple for REITs
P/CFE
CFE = net income + depreciation
Lots of depreciation
Common Multiple for Financial Services
Price/Book Value
Marked to market accounting
Common Multiple for Retailers
Revenue Multiples
Margins usually normalize
Common Multiple for Mining and Resources
P/NAV, P/CF, EV/Resources
Suitable for resource companies in different stages
What are the steps for conducting a comparable analysis?
Identify comparable companies (risk and return profile, industry/sector, business model, etc.).
Collect necessary financial information (e.g., SEC filings, Sedar+, research reports).
Choose and calculate multiples (commonly used in the sector; adjust financials if needed).
Benchmark the comparable companies (consider discrepancies in size, growth rates, margin, leverage, etc.).
Determine valuation.
What are the key points to remember about relative valuation?
The usefulness of a multiple depends on how comparable the firms really are; sometimes, there aren’t many comparable firms.
The comparables approach does not account for important differences across firms (e.g., exceptionally good management, new product development).
Comparables only provide information about relative values, making it pricing, not valuation.
Multiples are based on prices of actual firms in current market conditions, rather than possibly unrealistic forecasts of future cash flows.
All valuation methods are highly uncertain, so most practitioners use a combination of approaches (discounted cash flows and multiples) and look for consistency.
