As we mentioned earlier, comparable company analysis attempts to value companies based on how similar assets are priced currently in the market.
We will use a traditional P/E approach to illustrate the process (although EV / EBITDA is more commonly used within IB).
Step 1 − Identify the comparable universe Target company:
Step 2 − Focus on the appropriate metric Equity valuation
Use a PE ratio
Step 3 − Standardise the metric
Calculate PE multiples for 4 comparable companies
PE multiples
Step 4 − Value the target
Using an average multiple of 16.8x earnings to value easyJet
Comparable PE 16.8x
easyJet forward EPS (p) 37.5 Implied equity value (p) 630.00 Identify the
Step 1 – Identify the comparable universe
The above illustration is attempting to value an equity share of easyJet plc, using comparable company analysis. The fi rst step is to select a comparable universe of companies that will be used to value the target company, easyJet plc. The selection of an appropriate comparable universe is the cornerstone of comps. The detail on how a comparable universe is
the comparable universe should contain companies that display similar characteristics to easyJet plc. This universe will be used to derive a valuation for easyJet plc based on how the universe is priced currently in the market.
For the purposes of this example, the comparable universe has been identifi ed as:
Ryanair AirAsia Jetstar Virgin Blue.
Checkpoint – Choosing the comparable universe
Choose an inappropriate universe and the valuation will be fl awed – poor sample Ë poor valuation.
Step 2 – Focus on the appropriate metric
Comps analysis can value companies at the equity level as well as at the enterprise level. This example illustrates an equity level valuation of easyJet using comparable P/E multiples.
Step 3 – Standardise the metric
Step 3 involves calculating P/E multiples for the comparable companies.
It is vital that the multiples are calculated in a consistent manner across the sample. Otherwise, differences in the calculations will introduce “noise”
into the valuation. For instance, the P/E multiples were all calculated using forward earnings estimates. This must be done consistently across the sample. A comparable universe where the multiples have been calculated using a mixture of forward, current and trailing earnings numbers is of little use.
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PE multiples
(Forward)
Ryanair 17.2x AirAsia 18.0x Jetstar 15.0x
Virgin Blue 17.0x
Average 16.8x
Once we have a consistent set of comparable multiples, the target can be valued.
Checkpoint – The issue of consistency
Consistency is THE key concept that needs to be reinforced throughout the comps process. Inconsistent comparable companies and calculations will lead to an incorrect valuation.
N.B.: As well as standardising for period of earnings, also calendarise for different year / ends.
Step 4 – Valuing the target company
Once there is a well defi ned comparable universe along with a set of consistently calculated multiples, the target company can be valued.
A crucial decision is the size of the multiple to use to value the target company, easyJet plc. The comparable universe provides P/E multiples ranging from 15.0x to 18.0x earnings, with an average 16.8x.
easyJet plc could be valued by applying any of these multiples to its own earnings number. Clearly, the choice of a multiple between 15.0x and 18.0x will have a material impact on the implied equity valuation.
A key decision of the analyst will be to decide what size of multiple will be appropriate to value easyJet plc. The decision is not as simple as plumping for the average. Using the average as the comparable multiple to value easyJet plc is implying easyJet plc would be an average company within the comparable universe and therefore valued at a premium to those trading below the average P/E and at a discount to those trading above the average P/E.
The analyst may believe, because of his or her knowledge of the company and the circumstances surrounding the valuation, that easyJet plc should be valued using a comparable multiple at a premium or a discount to the average of the comparable universe. This is a judgement call based on experience, knowledge and skill, backed up by appropriate analysis e.g.:
Review of sector Key Performance Indicators (KPIs) Quality of assets, brand, etc. relative to industry peers.
Using an average multiple of 16.8x earnings to value easyJet
Comparable PE 16.8x
easyJet forecast EPS (p) 37.5
Average 630.00
Once the appropriate comparable multiple has been determined, the target can be valued. A comparable multiple applied to an EPS number will produce an implied equity value per share. The same multiple applied to an earnings number will produce an implied total equity value.
Checkpoint – The issue of consistency – again
Consistency is again an issue. As the comparable multiples are forward PE multiples, the EPS used to produce the implied equity value per share must be a forward EPS estimate.
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Step 1 − Identify the comparable universe of companies
Comps valuation requires in-depth understanding of the target company and its peers. Comps valuation multiples will only be useful if the companies in the comparable universe are truly comparable. A comparable company is one with cash fl ows, growth potential and risk characteristics similar to the fi rm being valued. Furthermore, a comparable company may not be in the same sector as the target company. For example, a telecoms fi rm could be included in the comparable universe used to value a software company, if the cash, risk and growth profi les were comparable.
As no two companies are exactly the same, the most similar companies are sought.
The companies (both target and comparable) should have similar:
Business activities – industry, products and distribution channels Geographical location
Size (turnover / market capitalisation) Business model
Growth profi les (including growth prospects, seasonality and cyclicality) M&A profi les
Profi tability profi les Cost structure
Capital structure (including the credit rating) Ownership structure (including the free fl oat)
Accounting policies (the accounting rules that the company follows) Market liquidity of the securities
Breadth of research coverage.
Often, it is only when data is collected on a wide range of companies (including the target) and calculations performed on the numerical aspects above (e.g. profi tability, historic growth etc.) that it becomes clear which companies are truly comparable with the target.
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If equity level comps are to be used, similar capital structures are essential.
Accounting policies Growth, profit and
M&A profile
Geographical location Size
Cost and financial structure
Ownership structure Identify the comparable universe
Business activities Business
model
Checkpoint – Choosing the comparable universe
Select the universe of comparable companies carefully − more is not necessarily better.
Step 2 – Focus on the appropriate fi nancial metrics and ratios
Multiples are easy to use and easy to misuse. Having identifi ed what is believed to be an appropriate comparable universe, comparable multiples must be calculated.
The following questions must be answered at this stage:
What level of valuation are we seeking – equity or enterprise value level?
Which profi t metric should be used?