Step 1 - Determining the Peer Group
Just like the name implies you are searching for "comparable companies." You determine a company as being comparable based on both financial and qualitative characteristics:
- Business & Industry: do your peers sell similar products?
- Geography: do your peers operate in similar geographic locations?
- Size: do your peers have similar market caps?
How to find peers:
- Competition Section of your Target Company's 10-k (click the button below to search the SEC's public company filings tool, EDGAR)
- Equity Research Reports
*A disadvantage of comparable company analysis is that sometimes it is difficult to find true peers to your company, for example, Walt Disney Corporation operates across so many different business lines that it has no directly comparable peers.
Step 2 - Determining the Multiples to measure
Multiples are created by dividing a measure of the company's value, such as, Enterprise Value or Market Capital (typically use Price as it is simply Market Cap. divided by Shares Outstanding) by a measure of the company's performance, such as EBIT or Sales.
There are three types of multiples:
- Enterprise Value Multiples: these look at the whole capital structure of a company (its Debt and Equity) and place Enterprise Value in the numerator of the multiple. To create a enterprise multiple you must use a financial metric in the denominator that similarly is attributable to the full capital structure of the company, such as, EBITDA. The metric in the denominator must be a measure of the company's performance that are available to all investors and so must be prior to any distributions to investors such as, interest expense or preferred dividends. Some common EV multiples include:
- EV / EBITDA
- EV / EBIT
- EV / Sales
- EV / Unlevered Free Cash Flow
- Equity Value Multiples: these look merely at the equity portion of the capital structure and place Price in the numerator of the multiple. To create an equity value multiple you must use a financial metric in the denominator that similarly is attributable to simply the stockholders of the company, such as, Earnings per Share. The metric in the denominator must be a measure of the company's performance that are available to the shareholders and must be after any distributions to investors, such as, interest expense or preferred dividends. Some common Equity Value multiples include:
- Price / Earnings Per Share
- Price / Book Value Per Share
- Industry Specific Multiples: these multiples provide more accurate measures of a companies performance within their various industries. Some examples of industry specific multiples include;
- Oil & Gas - Total Reserves / Annual Production
- Retail - Sales / Total Square Footage
- Airline - Total Passenger Revenue / Available Seat miles
Based on the company you are valuing and its industry, you must determine which multiples are relevant to your valuation. P/E and EV/EBITDA are fairly universal metrics across most industries. However, within some industries certain multiples that are preferred above others. For example, when valuing a managed-care company a P/E multiple is the preferred multiple to use for developing a range.
To Learn More about the Concepts behind the P/E and EV/EBITDA ratios, click the link below and visit our supplementary videos page
Step 3 - Collecting the Data
Once you have determined the multiples you will be using for your analysis, you must collect the data to create the metrics.
There are three types of data you can use: Historical, Current or Forward Looking. It is more common to use forward looking data because of the fact that investors are valuing the company based on its future prospects and so the metrics you derive should similarly look towards the future. However certain pieces of information must be current, such as Enterprise Value and Price.
Sources of Data:
- Company 10-k & 10-q's
- Equity Research Reports and Forecasts
Step 4 - Spreading the COMPS
Below you will find a very basic comps model for you to practice the three steps above.
The model derives a P/E Multiple for each peer by dividing Market Cap by Net Income (an OVERSIMPLIFIED way of deriving Price-to-Earnings). The EV/EBITDA multiple is derived for each peer by dividing its respective Enterprise Value by its EBITDA. The Min, 1st Quartile, Median, 3rd Quartile, and Max are derived for the peers' P/E multiple and EV/EBITDA multiples.
You must note, that typically this step of the process is the longest, as creating the multiples for the individual companies means scrubbing and adjusting all of their financial metrics to be on an "apples to apples" basis. This is typically done company by company and the clean worksheet shown below is an oversimplified version of the phase when you compare against your target company.
A further discussion on how the implied share price for the target is determined using its peers, follows the model.
Now Simply go ahead and input the data into the cells with blue font (blue font is an indicator that the inputs are supposed to be changed), and continue reading!
The Implied Share Price
Above you inputted data available to everyone in the public and like magic the model spit out an implied share price range for your target company...well not quite.
The range being shown on the graph for the respective valuation multiples is being derived by taking the 1st Quartile, Median, and 3rd Quartile P/E and EV/EBITDA multiples and multiplying them by the target company's metric.
For example. Look at the 1st Quartile P/E multiple derived from the comparable companies. Now multiply that number by the Net Income of your Target Company divided by the Target Company's Shares Outstanding (essentially Earnings Per Share). The result should be the bottom limit on the P/E's implied share price for your target company.
The calculation using the EV/EBITDA multiple required some more computation as its numerator is Enterprise value so simply multiplying one of the EV/EBITDA multiples by the target company's EBITDA, would result in the Target company's Enterprise Value. The Enterprise Value is the value of the firm available to all investors. To back into the Price per Share (value of the firm available only to Equity, or specifically common stockholders), you must subtract the target company's Net Debt (Total Debt minus Cash & Equivalents) from the Enterprise Value. The resulting number is now equivalent to Equity Value and when divided by the target company's shares outstanding results in its implied share price.
The comparable company derived ranges provide an idea of where the company should be trading at (Price) or being valued at as a whole (Enterprise Value) based on how its peers are being valued.
The comparable company analysis, although extremely popular, has its pitfalls including but not limited to:
- it can be difficult to find true comparable peers because you are using simply public data and some companies that may fall into your peer group are not public, and/or your company is simply operating in a completely unique space.
- market conditions and sentiment strongly influence comps valuations, and can be swayed by short term swings in the market
Although you may feel like a master at Comps, now that you've read the guide and actually filled in a model, you are not! Keep in mind that the above model is extremely simplified for the purpose of getting the concept across. You are certainly more prepared than any of your peers probably are, and hopefully have developed a working knowledge of how a comps works. Finally note that the above model is merely a piece of what should be used when conducting any valuation. You should create full-blown operating model, with balance sheet, statement of cash flows, and income statement projected out as well, and audit each comparable companies financials individually. Please continue learning with our other models (suggestion: The Precedent Transactions Model is the best next step).