Modelling Innovation CHAPTER 6

Chapter 6 - Comparable companies analysis

Comparable companies analysis is the most frequently used valuation method in financial markets, particularly for quoted companies. Based on public information, the share price is used to calculate the equity value and, adding net debt, the enterprise value of a basket of companies in the same sector is calculated. These amounts are then compared with the companies revenues, EBITDA, EBIT or any other financial or operating metric to obtain a multiple. The analysis thus reflects market sentiment: the average multiples of a basket of similar companies, is attributed to the financial metrics of a target company to derive a valuation. If the markets were right, the intrinsic valuation using the DCF methodology and the relative valuation based on comparable companies analysis would converge. If there is a difference between these two approaches, which is almost always the case, we can assume that either the DCFs assumptions are not correct or that equity markets are overstating or understating the value of the company. In the context of an acquisition, it is relevant to note that comparable companies analysis does not reflect control premiums nor potential synergies and as a result, valuing a potential target using this method does not take into account the benefits and value implications of an acquisition. The relevance of this method is dependent on the extent the companies selected are really comparable to the company being analysed. From the mechanics point of view, certain adjustments are needed to make the multiples relevant.

6.1.

What is the Efficient Market Hypothesis (EMH)?

The Efficient Market Hypothesis (EMH) was developed in 1970 by Eugene Fama and dictates that at any point in time, market prices reflect all available information about a companys value. In order to draw a different conclusion from the market, the analyst would therefore need to have access to inside information (which eliminates the EMH assumption of symmetry of information). EMH is a working hypothesis, which is needed to develop working theoretical models. Several relevant economists and specialists have disagreed with this theory, Krugman noted that investors have mass behaviour1, focusing on certain actions and leaving aside others, which results in distorted share prices. Aside from the critics, how does this theory explain the performance of Warren Buffett and other successful investors who systematically manage to outperform the markets benchmark returns? If this hypothesis were always valid, in an extreme case, the DCF method would not be needed. In practice, this theory falls through due to the imperfect and inefficient behaviour of supply and demand in the

Paul Krugman, "School for Scoundrels", New York Times Sunday Book Review, 9, August 2009 1

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capital markets. The practical consequence is that a credible valuation should take into account both the DCF and other relative valuation methods. The true value of a company can be estimated with greater accuracy by comparing the outcomes of different methods.

6.2.

How is a Comparable Companies Analysis structured?

Identify Comparable Companies

Focus on relevant Multiples

Adjust parameters to enable comparison

Conclusions of the Analysis

Identify comparable companies

The first step in applying the analysis is to identify a basket of comparable companies that will be analysed to extract relevant and reliable (comparable)

multiples. Depending on the company being valued, different factors should be taken into account, as described below in Table 1.

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Table 1 - Relevant factors in identifying comparable companies Sector What are the companys main products? What are its main customers? Where does this company operate? Dimension Are the revenues of this company comparable to the company analysed? Is the market capitalisation comparable? Positioning Level of Operational margins (EBITA). Growth perspectives. Credit Factors Capital Structure. Credit Rating. Liquidity Issues. Shareholders Shareholder structure. Liquidity.

The choice of comparable firms is subject to the process presented in the diagram below. After choosing the correct Region, the comparable firm should be analysed according to Industry, Size and Activity or Product (Step 1). After the chosen comparable company is analysed, another Region is chosen and, subsequently, other comparable companies are chosen as well (Step 2). The amount of companies chosen is important: while the analysis should include as much information as possible, using too many companies might create an inefficient analysis with companies that are different from the company that is being analysed. In practice, three or four companies per region is considered an appropriate level of detail. Diagram 1 Identify comparable companies

Step 1
Activity Size Product

Region

Industry

Size

Step 2

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Focus on relevant multiples

Step two consists in focusing the analysis on relevant multiples. Depending on the company that is being analysed and its sector of activity, the most relevant multiples differ. The following table shows examples of relevant multiples by sector: Table 2 - Relevant multiples by sector Sector Energy, oil & gas Multiples

Banks/financial intermediaries Industry Natural resources (mining etc.) Media Telecommunications

(BV = Book Value per share)

Most companies: Chemicals: Most companies: Gold: Cable and satellite: Cinema exhibition: Fixed and mobile:

In the case of oil & gas companies for instance, the EV can be compared to the value of reserves (P1 being proven reserves, P2 probable reserves). For banks, the price per share can be compared to the book value per share to determine the relationship between the markets valuation and the amount of capital i n the balance sheet. In the case of industrial companies, EV/EBITDA is the most widely used multiple. Some industrial companies are capital intensive and the EBITDA, which is a measure prior to D&A, is the right financial indicator that enables a meaningful comparison of companies with newer vs. older asset bases. The examples above are simply illustrations and sector knowledge is essential to perform a meaningful valuation using comparable companies.

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Adjust parameters to enable comparison

After choosing the comparable companies, some adjustments should be made to prepare an efficient comparison. Some companies may have different

financial year ends and therefore, the financial figures should be adjusted to enable a meaningful comparison. The adjustment is shown in the diagram below.

6.3.

Calendar adjustments
Diagram 2 Calendar adjustments Some companies have different periods in which their financial statements are organized. Some financial years end in December and some end

in June, therefore if the comparison is made between two companies with different financial year endings, an adjustment must be made. The diagram below represents the issue in two different timelines: Year 0 End in December End in June End in June Year 1 End in December

Valuation Period An example of calendar adjustments is given below with projected revenues: End of year Company A December Company B June Year 0 200 150 Year 0 220 160

Company Bs calendar adjustments are given by the following equation:

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Other adjustments can also be made in order to make the chosen companies more comparable. The current share volume of a company, for example, is important to determine the Price-to-Earnings multiple. To determine the share volume the analyst should start with the authorized number of shares, and include are non-issued shares that were attributed to management as part of option plans. The methodology for determining the right volume of shares is described below.

6.4.

Adjusting the number of shares

Diagram 3 Share Volume Adjustments

Non-issued but authorised

Authorized

Issued

Options
(convertible bonds, etc.)

Fully Diluted Share Volume

6.5.

Multiples interpretation

The range of multiples described above have their own interpretation when delivering information about the true value of the company. Profit multiples are normally the Price-to-Earnings ratio and EV/EBITDA ratio, if these ratios are below the sector average then it could mean that the company is facing intense

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competition, or that there are few growth perspectives. The reverse is also true, the reasons that lead these multiples to be high are the same reasons that these companies DCF is also high which are high growth perspectives and high return of invested capital. Revenue multiples are normally used for start-ups or for companies that have negative operational revenues. The EV/EBITDA ratio is frequently used as it enables a broader valuation of the company, independent from its capital structure. This, however, allows the company to increase its debt levels without the effect being captured by the multiple. The interpretations of the position of the companys multiples, relative to the sector average are shown below. If the companys multiples are above the sectors average: Market factors o o Corporate governance Company risk

Operational Factors o o o o o Advantage relative to competition Closed domestic market Operational efficiency Better growth prospects Lower cost of capital

If the companys multiples are below the sectors average: Market and financial structure factors o o Lack of liquidity Excessive use of debt

Operational Factors o Disadvantage toward competitors

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Lack of credibility of the management team

The figures alone are not enough to substantiate a companys valuation based on this analysis. The analyst should confront the multiples with the companys operational and financial reality.

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