Relative Valuation Flashcards
What is the purpose of using multiples in valuation?
A valuation multiple is a financial ratio that reflects how valuable a particular company is in relation to a specific metric. The numerator will be a measure of value such as equity value or enterprise value, whereas the denominator will be a financial or operating metric.
Since absolute values cannot be compared, multiples are used to standardize a company’s value on a per-unit basis. This enables comparisons in value amongst similar companies, which is the premise of relative valuation. For any valuation multiple to be meaningful, a contextual understanding of the target company, such as its fundamental drivers and general industry knowledge, is required.
How do you determine what the appropriate numerator is for a multiple?
For multiples, the represented stakeholders in the numerator and denominator must match.
If the numerator is enterprise value, metrics such as EBIT, EBITDA, unlevered free cash flow (FCFF), and revenue multiples can be used since these are all unlevered (i.e., pre-debt) measures of profitability.
In contrast, if the numerator is equity value, metrics such as net income, levered free cash flow (FCFE), and earning per share (EPS) would be used because these are all levered (i.e., post-debt) measures.
Walk me through the process of “spreading comps.”
Before you can answer the question, you must ask for clarification on whether the interviewer is asking about trading or transaction comps. The processes for both, however, have many overlapping aspects.
1. Determine Comparable Peer Group: The first step to perform comps is to select the peer group. For trading comps, the peer group will be composed of publicly traded comparable companies that are competitors in the same industry or operate within a nearby industry. For transaction comps, the peer group would include companies recently involved in M&A deals within the same or a similar industry.
2. Collect Relevant Information: The next step involves finding publicly available information that may be helpful to understand the trends and factors affecting how companies in a particular industry are being (or were) valued. Most of the insights gathered in this step will be more on the qualitative side and related to industry research, understanding ongoing developments, and company-specific details.
3. Input Financials: With the industry research completed, you’ll then pull the financial data of each comparable company and then “scrub” the financials for non-recurring items, accounting differences, financial leverage differences, and business life cycles (cyclicality, seasonality) to ensure consistency and allow for a fair comparison among the companies. If relevant, you’ll also calendarize each peer group company’s financials to standardize the metrics to ensure comparability.
4. Multiples Calculation: Then, the peer group’s valuation multiples will be calculated and benchmarked in the output sheet. At a minimum, the multiples are shown on a last twelve months (LTM) and the next fiscal year (NTM) basis, and as a general convention, the minimum, maximum, 25th percentile, 75th percentile, mean and median will be listed. Using the research collected in previous steps, you’ll then attempt to understand the factors causing the differences and remove any outliers if deemed appropriate.
5. Apply Multiple to Target: In the last step, the target company being valued will have the median (or mean) multiple applied to the corresponding metric to arrive at its approximate comps-derived value. Understanding the fundamental drivers used to value companies within a particular industry makes comps-derived valuations defensible – otherwise, justifying whether the target should be valued on the higher or lower end of the valuation range will be difficult.
When putting together a peer group for comps, what would some key considerations be?
Operational Profile: These characteristics entail the nature of the business, such as its industry, business model, products/services sold, and end markets served. In addition, the company’s position within the market (market leader or market challenger), stage in the life cycle, and seasonality/cyclicality should all be considered. The importance of selecting the right peer group for a comps-derived valuation cannot be overstated, and this begins with understanding the target’s operational characteristics.
Financial Profile: If the company might be a suitable inclusion to the peer group based on its operational characteristics, its financial profile would then be considered. Some metrics to gather would be the company’s key cash flow metrics, size in terms of valuation, profitability margins, credit ratios, historical/estimated growth rates, and return metrics.
Should the target company being valued be included in its peer group?
Many professionals exclude the target company being valued from the peer group because the target’s inclusion would skew the multiple towards the target’s current valuation. However, if the intuition behind a comps analysis is that the market may misprice individual stocks but is correct on the whole, then logic dictates that the target should be included in its market-based valuation.
What are the primary advantages of the trading comps approach?
Public Filings: Trading comps involves public companies, making data collection far more convenient since all their reports and filings are easily accessible online.
Less Data Required: Implementation is a key advantage of trading comps, as proper DCFs cannot be built without detailed financials and supplementary data. But to get a decent trading comps-based valuation, only a few data points (e.g., EBITDA, revenue, net income) are required, making it easier to value companies when access to data sets is limited.
Current Valuations: Trading comps reflect up-to-date, current valuations based on investor sentiment as of the present day, since it’s based on the latest prices paid in the public markets.
What are the main disadvantages of performing trading comps?
Putting together a peer group of “pure-play” companies by itself can be a challenging task, especially if the target is differentiated and has few (or no) direct competitors.
Even with a well-thought-out, similar peer group, explaining the differences in valuation can be difficult as the comparison is always “apples to oranges.” Understanding valuation gaps between a company and its comparables involves judgment, which can be very challenging – plus, the market is often emotional and fluctuates irrationally, bringing in more external factors to consider.Low trade volume and less followed equities may not reflect their true fundamental value, making them less useful for trading comps.
To perform transaction comps, how would you compile the data?
When collecting the data to perform transaction comps, you would use deal announcement press releases, proxy filings, and the merger agreement to learn about the deal terms. You would also use the target company’s filings (annual and quarterly reports) for historical financial data, research reports, and financial data vendors such as Bloomberg, Capital IQ, or FactSet for historical share price data and estimated earnings forecasts.
What do transaction comps tell you that trading comps cannot?
Transaction comps can provide insights into control premiums that buyers and sellers should expect when negotiating a transaction.
In addition, transaction comps can validate potential buyers’ existence in the private markets and if a particular investment strategy has been successfully implemented before. Let’s say a certain company is valued at a specific price based on a DCF analysis and
confirmed to be within range by trading comps. However, if there are no buyers in the market, the seller is unlikely to exit at its expected valuation.
In M&A, why is a control premium paid?
A control premium refers to the amount an acquirer paid over the market trading value of the shares being acquired (usually shown as a percentage). As a practical matter, a control premium is necessary to incentivize existing shareholders to sell their shares. It’s improbable that an acquirer could get a controlling interest in a target company without first offering a reasonable purpose premium over the current price.
From the perspective of the shareholders of the acquisition target: “What would compel existing shareholders to give up their ownership if doing so is not profitable?”
Besides incentivizing existing shareholders to sell, what other factors lead to higher control premiums being paid?
Competitive Deals: In M&A, nearly all acquirers pay a control premium due to the competitive elements of sale processes. As a general rule, the control premium paid will be higher the more buyers are involved, as competition directly drives up the price.
Synergies: If there are potential synergies that can be realized by the acquirer and the management team has high conviction in its occurrence, then the acquirer might be justified in paying a higher premium. Asset Scarcity: Many acquirers (strategics in the majority of cases) might pay a higher premium if the specific asset is a centerpiece to their future plans and there are no other acquisition targets in the market that meet their criteria. Oftentimes, this acquisition could lead to a meaningful competitive advantage for the acquirer over the rest of the market, making the completion of this acquisition a necessity. Undervalued Target: The target company might be perceived to be significantly undervalued from the buyer’s viewpoint. From their perspective, the purchase price could be a moderate premium when compared to their own fair value assessment of the target, whereas to others the buyer paid an unreasonably high premium.
Mismanagement: A mismanaged company coincides with the previous point, as this typically leads to underperformance. The acquirer will most likely be under the impression that the management should be replaced, and through operational improvements, a significant amount of value that is currently not being fully taken advantage of could be derived. Thus, a target acquired for this reason will be immediately restructured, beginning with the management team being replaced post-closing.
Why is transaction comps analysis often more challenging than trading comps?
Performing comparable acquisition analysis can be challenging when there has been limited (or no) M&A activity within the relevant space, or the comparable transactions were completed a long time ago in a completely different economic environment. Data from those prices paid might not reflect current market trends and investor sentiment.
The transaction dates place a significant constraint on the pool of comparable transactions. Generally, only relatively recent transactions (within the last five years) offer insight into industry valuations.
The transaction context must also be looked at, such as the form of consideration, the
type of buyer (financial or strategic), and the deal’s circumstances, which can
significantly influence the final purchase price. However, this information about the deal can be challenging to compile, especially when they involve private companies, as they’re not required to disclose all this deal- related information. Most times, even the purchase price paid for a company may not even be announced – thus, the data found is “spotty” and less straight-forward than trading comps.
When putting together a peer group for transaction comps, what questions would you ask?
What was the transaction rationale from both the buyer and seller’s perspective? Was the acquirer a strategic or a financial buyer?
How competitive was the sale process?
Was the transaction an auction process or negotiated sale?
What were the economic conditions at the time of the deal?
Was the transaction hostile or friendly?
What was the purchase consideration?
If the industry is cyclical (or seasonal), did the transaction close at a high or low point in the cycle?
When valuing a company using multiples, what are the trade-offs of using LTM vs. forward multiples?
Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA, EBIT, and EPS forecasts are subjective and especially problematic for smaller public firms, whose guidance is less reliable and harder to obtain.
That said, LTM suffers from the problem that historical results are often distorted by non-recurring expenses and income, misrepresenting the company’s recurring operating performance. When using LTM results, non- recurring items must be excluded to get a “clean” multiple. In addition, companies are often acquired based on their future potential, making forward multiples more relevant.
Therefore, both LTM and forward multiples are often presented side-by-side, rather than picking one.
Why might two companies with identical growth and cost of capital trade at different P/E
multiples?
Growth and cost of capital are not the only drivers of value. Another critical component is the return on invested capital (ROIC). Besides having different ROICs, the two companies could very well just be in different industries or geographies.
Other reasons may include relative mispricing or inconsistent EPS calculations, often caused by non-recurring items or different accounting policies.
