How much is a company worth? Is it undervalued or overvalued? Analysts apply a few approaches to calculate the number, including Precedent Transactions Analysis, Public Comparables or Comparable Company analysis which we will walk you through in this article, and Intrinsic Valuation Model – Discounted Cash Flow (DCF).
In terms of information available in the market, analysts tend to glean financial data much more easily for their analysis when applying Comparable Company Analysis since comparable companies mostly are public ones. This is opposed to Precedent Transactions Analysis or Private Comparables because public firms also do transactions and they are required to publish the terms and conditions.
Definition: Comparable Company Analysis (CCA), also known as Public Comparables or Public Comps for short, is a valuation technique used by analysts to gauge how much a company’s valuation is. To conduct CCA, analysts select a set of comparable public companies, operating in the similar industry or sector and location to the valuation company, then compare the valuation company with those companies to estimate its value which can be fairly traded in the market.
This methodology is based on the same logic that companies doing businesses in the same industry/sector with many other relatively similar factors should have similar multiples and metrics such as Enterprise Value to sales (EV/S), Price to Earnings (P/E), for example. Hence, they should be valued similarly.
- Company X has an Enterprise Value of $100M, its EBITDA is $20M. An EV/EBITDA is equal to 5x. We need to recalculate the value of Company X since it looks to be undervalued compared with the market price.
- Another company, let’s say, called Company Y operating in the identical sector and located in the same geographic region, has an Enterprise Value of $150M and EBITDA value of $25M. Therefore, an EV/EBITDA is 6x.
- Similarly, Company Z has an EV/EBITDA multiple of 8x.
All other things being equal, Company X could be valued with EV/EBITDA multiples from 6x to 8x, at the Enterprise Value of between $120M and $160M. We could draw a conclusion that Company X is undervalued, and its EV could be up to $160M.
That’s how an analyst conducts a CCA at a basic level, of course, for the sake of simplicity. In practice, performing CCA is not that simple, requiring a lot of efforts to gather information and perform complex calculations on Excel.
These are steps generally taken by an analyst to perform Comparable Company Analysis:
Step 1: Create a comparable public companies list
- There are three main sources for you to select comparable companies and get financial information including: Capital IQ, Finviz, Yahoo Finance. In which, Capital IT requires you to log in, while the remaining two sources enable you to access financial information to a certain extent.
- The most ideal number of comparable companies are 5 – 10, though it depends on the industry you perform analysis. The more you narrow down, the more precise comparables list it can generate.
How to do: From the homepage of Finviz, Click “Screener”, the box like below will appear. To make the most precise comparable lists, at least three boxes you have to do is: Sector, Industry and Country (Geography Similarity).
The result presents some of the metrics and multiples like Market Cap, P/E, Price, Change, Volume. You can pick up a few companies on the lists generated from the website to create a set of comparable companies. The companies with the homogenous growth characteristics, industry focus, and other criteria are best choices to put in a peer universe.
Step 2: Refine the lists and Determine the metrics and multiples to apply
How to find the implied equity and enterprise value for transactions?
When a company is bought, the purchase agreement in-the-money dilutive securities get cashed out or get converted into an equivalent number of the buyer’s securities. Either of those scenarios would cost the buyer something when it acquires the company in question. Equity value is like the sticker price saying how much it costs to buy the company. However, there are additional items that can push up or push down the effective price afterwards, so the actual cost of buying that company might be different from the sticker price. This actual price is the enterprise value.
Depending on the acquired stakes and other stipulations in the purchase agreement, ways of valuing a company might vary. In the case that the acquirers buy up 100% of the target company, equity value is the equity consideration to be paid by the bidder. In the case that the acquirers only buy parts of the company, the equity needs to be grossed up to account for 100% of the target company’s value. For example, if company A gives the company B $1 million for 50% of their company, the equity value of company B is $2 million.
Enterprise value is calculated using this formula:
Enterprise Value = Equity Value + Debt + Preferred Stock + Noncontrolling Interests – Cash & Cash-Equivalents
These are common metrics and multiples usually used by analysts to perform the CCA:
|Revenue or Sales|
An amount of money presenting how much the company operation can generate.
The formula for Enterprise Value is stated above, it is different from Market Capitalization (Equity Value) of a firm.
|EV/Revenue – Enterprise value to Revenue|
The total value of a company (accounting for its stocks, debt, cash) to its annual revenue. It allows analysts to gauge whether the company is valued at the fair price. For example, if the EV/R is low, the company may be undervalued.
|EBITDA||A type of income standing for Earning Before Interests, Depreciations and Amortizations. It acts as a proxy for cash flow generated from the firm’s operation.|
|EV/EBITDA – Enterprise value to EBITDA|
A popular multiple used in valuation, It gives analysts an idea of how much it costs to acquire a firm compared with the value of EBITDA (how many times EBITDA you have to pay).
|PE – Price to Earnings|
Measures a company’s current share price relative to its earning per share (EPS)- calculated by dividing the company’s profit by the number of outstanding shares. This multiple gives analysts the profitability of a company relatively.
Step 3: Calculate the metrics and multiples of peer companies
After refining the comparables list, you calculate each company’s multiples and metrics. Calculation results then will be applied to derive the value of the valuation company.
The important values that should be derived firstly are Equity Value and Enterprise Value (Formula above). SInce they are publicly traded companies, you can obtain the financial datas easily on the internet with sources such as Finviz, Yahoo Finance. Both historical datas and projected datas (if any) are important equally.
In practice, it is tricky to retrieve those financial datas from peer companies since the information disseminated on the internet is not complete.
Many people question how accurate the estimation can be. We couldn’t make sure completely that the valuation company would be valued equally to what we expect and estimate. It can be either right or wrong, yet it doesn’t matter since most of the projections are for reference and the base to make acquisition decisions, no need to arrive at a hundred percent precise number.
Step 4: Use the multiples and metrics to determine a valuation range for the target company
Now that you have values of multiples and metrics needed. You can determine a range for the valuation company.
The important part here is to identify outlying variables. This is usually done by making a basket of securities to compare with the valuation company while simultaneously comparing the peer group stock index with popular indices to determine the outlying variables.
As said in the quick example above, the valuation of the target company can be derived to the value between the lowest level and the highest level of EV.
Get back to the example: If the peer group has the range for EV/EBITDA from 6x to 8x, the EBITDA of the target company is 20M, the target company can be valued at an EV between $120M to $160M at best.
- More ideally, investors are willing to acquire at the higher price if it is a prospective company with potential growth in the future.
- Nonetheless, the company would be undervalued if its EV is less than $120M.
Determining the company to invest your money can be one of your interview questions. For example:
Question: Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk. Company A is trading at a 15 P/E multiple, while the other – Company B trades at 10 P/E. which would you prefer as an investment?
Answer: In most cases, people choose to invest in undervalued companies over overvalued companies. In this case, two firms have homogenous earnings, growth prospects, leverage, returns on capital and risk. You should choose Company B because its P/E multiple is lower than that of company A, it means company B is undervalued in the market. You can have more handsome returns in future compared without holding a portion of company A.
3. Pros and Cons of Comparable Companies Analysis and Useful Sources to Glean Datas
3.1 Pros and Cons
- It is easy to calculate with data made available widely since comparable companies are public companies
- It’s hinged on real market data, not overly optimistic projections
- It helps identify a benchmark value for multiples used in valuation
- It can be tricky to select an appropriate set of peer comparable companies for various reasons
- For thinly traded and highly volatile companies, CCA becomes less reliable
- The analysis is influenced by the current market conditions
- In the worst case scenario, there wouldn’t be any comparable companies to analyze if compulsory requirements aren’t met.
- There is a little likelihood the analysis would undervalue the target company’s future prospects.
3.2 Useful Sources
Choosing a relevant peer universe for valuation is important. Collecting relevant financial data from those peer comparable companies, however, is paramount. In the paragraph above, to create a list of comparable companies, you can go to Finviz, Yahoo Finance, and Capital IQ, etc. These websites provide financial datas for your analysis to a certain extent.
There are also several resources for a real banker/analyst to get data including:
- Company Filings: Filings such as 10K, Prospectus,.. can be found at the SEC website: http://www.sec.gov/. These files are granular and comprehensive reports required by SEC annually for public companies.
- Research Reports by Investment Banks: Equity Research Division in Investment Banks offers sell-side research reports at a banker/an analyst request. These reports performed by Investment Banks or Research Agencies are considered granular and as an excellent source of comparable companies. In practice, analysts use these reports for their analysis, rather than incomplete and shallow information published publicly.
- Bloomberg: It is one of the greatest resources in finance, generally, and CCA, specifically, where you can find peers and retrieve financial data. But here’s a thing, you have to register and pay a fee to use the tool.
4. Comparable Companies Analysis vs. Precedent Transactions Analysis vs. Discounted Cash Flow Analysis
Do you fathom how an analyst arrives at the value of a company?
However, Comparable Companies Analysis is not a sole method of valuation. Analysts apply three valuation methods flexibly depending on different circumstances. Also, CCA is not the most popular approach to estimate the value of a company. We have three ways, in which Discounted Cash Flow (Intrinsic Value Model) is much preferred because it can generate the most accurate value of a firm.
We sum up key points in using 3 different approaches that might be useful for you to have an overview of how a firm’s value is estimated by bankers/ analysts:
|Discounted Cash Flow Analysis||Comparable Companies Analysis||Precedent Transactions Analysis|
|Other names||Intrinsic Value Model||Trading Multiples, Peer Group Analysis||Comparable Transactions, M&A Comps|
|Approach||Intrinsic Approach||Relative Approach||Relative Approach|
|How does it work?||Analysts forecast the business’ free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital.||Analysts compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios.||Analysts compare the company in question to other businesses that have recently been sold or acquired in the same industry.|
|Valuation Metrics||Dividends, cash flow, and the growth rate for a single company||Multiples of similar companies||Multiples of similar transactions|
|When to use?||Lots of certainties in the future performance of the company/industry; Financials are transparent.||If no financial data is available; if there are significant uncertainties in the future operations of the business/industry outlook.||If no financial data is available; need to identify potential bidders and sellers.|