📈Corporate Strategy and Valuation Unit 13 – Relative Valuation: Multiples & Comparables

Key Concepts and Definitions

• Relative valuation assesses a company's value by comparing its financial metrics to those of similar companies (comparables or comps)
• Multiples are ratios used to compare a company's financial performance to its peers, industry averages, or historical values
  • Common multiples include price-to-earnings (P/E), enterprise value-to-EBITDA (EV/EBITDA), and price-to-sales (P/S)
• Comparable companies are firms with similar characteristics, such as industry, size, growth prospects, and risk profile
• Enterprise value (EV) represents the total value of a company, including both equity and debt
  • Calculated as market capitalization plus debt minus cash and cash equivalents
• EBITDA (earnings before interest, taxes, depreciation, and amortization) is a measure of a company's operating performance
• Normalized earnings adjust for one-time or non-recurring items to provide a more accurate representation of a company's ongoing financial performance

Types of Valuation Multiples

• Equity multiples compare a company's stock price to its earnings, sales, or book value
  • Examples include P/E, price-to-book (P/B), and price-to-sales (P/S)
• Enterprise value multiples compare a company's total value (equity and debt) to its earnings or revenue
  • Examples include EV/EBITDA, EV/sales, and EV/free cash flow (FCF)
• Forward multiples use projected future earnings or revenue, while trailing multiples use historical data
• Sector-specific multiples cater to the unique characteristics of certain industries (price-to-funds from operations for REITs)
• Growth-adjusted multiples, such as the PEG ratio (P/E divided by growth rate), account for differences in growth rates among comparables

Selecting Comparable Companies

• Identify companies in the same industry with similar business models, products, or services
• Consider companies of similar size, as measured by market capitalization, revenue, or assets
• Look for companies with comparable growth prospects, profitability, and risk profiles
• Adjust for differences in financial leverage, as highly leveraged companies may have distorted multiples
• Use a sufficient number of comparables to minimize the impact of outliers and ensure a representative sample
  • Aim for at least 5-10 comparable companies, depending on the industry and availability of data
• Be aware of geographic differences, as companies in different regions may face distinct economic conditions and regulatory environments

Calculating and Interpreting Multiples

• Calculate multiples using the appropriate financial metrics (stock price, earnings, revenue, etc.)
  • Example: P/E ratio = stock price / earnings per share (EPS)
• Compare a company's multiples to those of its peers, industry averages, or historical values
• Interpret higher multiples as a sign that the market expects stronger growth or profitability relative to comparables
• Consider the dispersion of multiples within the peer group, as a wide range may indicate differences in company-specific factors
• Use multiple valuation multiples to gain a more comprehensive understanding of a company's relative value
• Analyze trends in multiples over time to identify potential changes in market sentiment or company performance

Advantages and Limitations

• Advantages:
  • Relative valuation is simple, intuitive, and widely used in practice
  • Multiples are easy to calculate and interpret, even for non-financial professionals
  • Relative valuation incorporates market sentiment and expectations
• Limitations:
  • Selecting truly comparable companies can be challenging, especially in diverse or rapidly evolving industries
  • Multiples can be distorted by differences in accounting policies, one-time events, or financial leverage
  • Relative valuation assumes that the market is efficiently pricing comparables, which may not always be the case
  • Multiples provide a snapshot of relative value but do not capture the intrinsic value of a company's cash flows and growth potential

Industry-Specific Considerations

• Understand the key drivers of value in each industry, such as production capacity for oil and gas companies or assets under management for financial firms
• Use industry-specific multiples that best capture the value drivers and performance metrics of the sector
  • Examples: price-to-funds from operations (P/FFO) for REITs, price-to-net asset value (P/NAV) for natural resource companies
• Consider the impact of industry cycles and commodity prices on multiples for cyclical and resource-based sectors
• Be aware of regulatory changes or industry disruptions that may affect the comparability of companies within a sector
• Adjust for differences in business models or product mix among companies in the same industry

Practical Application and Case Studies

• Use relative valuation to identify potential investment opportunities or acquisition targets
  • Look for companies trading at a discount to their peers or industry averages
• Combine relative valuation with other valuation methods, such as discounted cash flow (DCF) analysis, to gain a more comprehensive view of a company's value
• Monitor changes in multiples over time to assess shifts in market sentiment or company performance
• Analyze case studies to understand how professionals apply relative valuation in real-world situations
  • Example: The valuation of a technology startup based on revenue multiples of comparable public companies
• Use relative valuation to communicate value to stakeholders, such as investors or management teams

Common Pitfalls and How to Avoid Them

• Relying on a single multiple or a small number of comparables
  • Use multiple valuation multiples and a diverse set of comparables to mitigate the impact of outliers or company-specific factors
• Failing to adjust for differences in financial leverage or accounting policies
  • Normalize financial metrics and adjust for leverage to ensure comparability across companies
• Ignoring industry-specific factors or market conditions
  • Consider the unique characteristics and value drivers of each industry, as well as the impact of macroeconomic factors on multiples
• Overreliance on historical data without considering future expectations
  • Incorporate forward-looking multiples based on projected earnings or revenue to capture market expectations
• Neglecting the limitations of relative valuation and using it as the sole basis for investment decisions
  • Use relative valuation in conjunction with other valuation methods and a thorough analysis of a company's fundamentals and growth prospects