Many small business owners – or large business owners for that matter – wonder what their business is worth. For those owners who have money and are particularly curious, they can hire a company valuation specialist to do a valuation just an appraiser would could come an do an appraisal of a house. For those who not only want to get a valuation for their company but who also want to understand the fundamental value drivers of their business, they can learn to do that valuation themselves. One such valuation method is the comparable companies analysis. Let’s have a look at what it involves.
The comparable companies analysis is one of the most common valuation methods used on Wall Street. This analysis uses the market prices of actively traded common stocks of publicly-traded companies with similar business risks and returns to estimate the market value of a business under consideration.
These comparable companies are known as “comps.” Finding the appropriate comps for a particular company is an art form and is the key to using the valuation technique effectively.
It is very important to pick companies as similar as possible to the subject company. The key measures of a potential comp’s comparability are industry segment, growth prospects and operating margins.
The major financial characteristics to consider when picking comps are size (revenues and operating earnings) and profitability. The major business and operating characteristics to consider are industry (SIC codes), products, geographic market and customers.
There are many resources you can use to go about finding comps. Once you have identified one public company as a good comp, you can look at some of the publicly-filed documents such as 10-Ks or proxies, which will often have sections on the company’s competitors. These sections are often a good place to find new comps. As new comps are found, you can repeat this process to find additional ones.
In addition to SEC filings like the 10-K, there are a lot of online databases with tools that will help identify a set of comps for you. Unfortunately, many of these databases require a subscription, so few people outside of an investment bank have access to them.
One free online database, though, is Yahoo Finance. This is often the perfect place to start looking for comps because it has links that identify competitors and also has links to SEC filings. Yahoo will also do a quick multiples analysis of these competitors, which will be our next step.
So when do you have enough comps? The answer to this question will vary depending upon the company you are trying to analyze. You should try to get as many comps as possible to get a more accurate analysis, but for some industries, there just aren’t a lot of public companies available.
It is hard to do a credible comparable companies analysis with fewer than four comps, but sometimes you just have to settle for fewer. On the other hand, pulling more than 30 comps may give you a more accurate reading, but it can be a pain pulling all the financial information necessary to do the analysis.
Crunching the Multiples
At the heart of the comparable companies analysis is the use of multiples to calculate valuation. Multiples are used to assign value in the analysis. They are relationships between value and the current financial results of a company. Multiples hinge on both the risk and a company’s operating performance.
Perhaps the most commonly known multiple is the price to earnings ratio or P/E multiple. It is derived by dividing the stock’s current market price by the company’s earnings per share (EPS) over the last twelve months. The higher the company’s expected earnings growth and the lower the perceived risk of the company, the higher the multiple.
The P/E multiple is just one of many multiples used in a typical comps analysis. It is best to look at several multiples in the analysis to determine which ones the market seems to use to value the comp set.
Types of Multiples
The are two general types of multiples – market value of equity multiples and enterprise value multiples. The market value of equity is the value owned by the company’s common stockholders as minority interests in a publicly-traded company on a fully-distributed basis. This value is what’s left after paying off the company’s debt. It can be calculated simply by multiplying the current stock price by the number of fully diluted shares outstanding.
A company’s enterprise value, however, also includes preferred stock, minority interests and net debt. The simplified version of this formula is:
Enterprise Value = Market Value of Equity + Preferred Stock + Minority Interests + Net Debt
The more detailed formula is a bit more complicated:
Enterprise Value = (Stock Price * Fully Diluted Shares Outstanding) + Preferred Stock + Minority Interests + (Long-term Debt + Short-term Debt – Cash & Cash Equivalents)
Enterprise value multiples use operating statistics that are before net interest expense and taxes. The reason for this is that the capital structure of the company (how much debt vs. equity it has) should not play a part in how it is valued. Therefore, interest, which would flow to debt investors, is taken out of the equation.
Commonly-used market value of equity multiples include:
Common Stock Price / LTM Earnings per Share (“EPS”)
Common Stock Price / Current Calendar Year (“CCY”) EPS
Common Stock Price / Next Calendar Year EPS
Common Stock Price / Tangible Book Value
Commonly-used enterprise value multiples include:
Enterprise Value / Revenue
Enterprise Value / Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”)
Enterprise Value / Earnings Before Interest and Taxes (“EBIT”)
EBITDA is a very valuable operating statistic used in many types of analysis because it is a measure of operating cash flow plus other recurring income and expenses. It is the most commonly cited multiple for enterprise value.
A Note on LTM
As we go about calculating some of these multiples, it’s important to understand the terminology. Sometimes investment bankers and finance types will loosely throw around acronyms such as LTM. LTM stands for latest twelve months or last twelve months.
This is a qualifier used for income statement operating statistics and is among the most common calculations performed in financial analysis. It is used to get a company’s latest available information without reference to when the company sets its fiscal year end.
Company’s would not be comparable if one company’s statistics are through December 31 and another company’s statistics are through March 31. To correct for this, we take the LTM financial statistics from both companies through March 31.
To calculate this, we have to look at the latest 10-K (annual financials) and 10 Q (quarterly financials) of each company. Let’s say we are performing this analysis in mid July and the company has a December 31 fiscal year-end. The latest available financials should be a 10 Q from June 30.
The 10 Q will have six months of financial information from January through June for this year and the same six months of financial information from last year. To calculate LTM revenue, we take the full twelve months of revenue figure from the 10-K, add the six months of revenue from the first part of this year from the 10 Q and subtract the six months of revenue from the first part of last year from the 10 Q. This now leaves us with the last twelve months of revenue ending June 30 of this year.
It is very important to be able to make these calculations for each of the comps selected based on the latest available financial information. This way, all figures will be on an apples-to-apples comparison basis. Be sure to look for earnings announcements in the SEC filed documents. If the latest 10 Q is not available and it is close to the due date for it, there is a chance the company as announced its earnings already. Once this has happened the market will value the stock price on these earnings even if the 10 Q (or 10-K) is not yet available.
Putting it All Together
So now that we have selected our comps and can pull the financial information to calculate the multiples, how do we organize this data? The best way to do comps is to pull together a spreadsheet template where you can easily input values from your research and it will automatically your multiples for you.
All the multiples for each comp selected can then be fed into a table – one comp on top of another – where summary statistics can be calculated. Summary statistics on the multiples set typically include minimum, maximum, mean and median values.
With all the multiples next to each other, it is now easier to spot outliers and other inconsistent data. For any multiples that look drastically different than the data set, you should go back to examine your calculations to make sure they are correct, and then check to see if there is anything about the company’s accounting methods that are causing a discrepancy.
Occasionally, there are some events that effect the companies stock price and are not yet reflected in the operating stats, so the multiples may be out of the typical range. Such events could include litigation against the company, a bid to acquire the company, natural disaster, etc. In these cases and others where the multiples of the comp are no longer applicable to the analysis, it may be appropriate to mark them as outliers and remove them from the comp set.
Finally, we can use the multiples statistics to calculate the value of the company in question. To do so, we pull together the same corresponding financial statistics for the company in question over the same period. We can then multiply them by the mean, median, minimum and maximum multiples of each of the statistics to identify an estimated value and range for each of the multiples.
If we use both enterprise value and equity value multiples, we’ll come up with a range of values for both the company’s enterprise value and its equity value. So what is the best multiple to look at? It varies from industry to industry and can even change over time. The EBITDA multiple is usually a good one, but for financial services companies, a balance sheet multiple might be more appropriate.
Take a look at the range of values in the multiples sets. Usually the multiple with the narrowest range of values will be a good indicator as to which multiple may have the most weight in your analysis.
Remember, performing a comparable companies analysis is an art, not a science, so it’s important to pay careful attention to how you select your comp set, how you spread the financial for each company and which multiples you favor in your analysis. Once you have completed the analysis, you will not only have a good sense of the value of the company you are analyzing, but you will also have a good sense of what drives value for this industry in the financial markets.