-> DEF: The value of an asset is compared to the values assessed by the market for similar or comparable assets.
- Used to estimate company value.
- Alternative methodology to the Intrinsic Method to evalueate the EV & E method.
- COMPARABLE COMPANIES: company that are compared that have been sold.
-> CHAR:
- Easy to compute (more than the intrinsic method which is based on the EV and the terminal value) and it is fast.
- If comparable companies correclty chose => Difficult to make huge mistakes.
- M&A are done by relative evaluation.
- We can compute the terminal value.
-> IS PERVASIVE:
- Most valuation on Wall Street are relative valuations;
- Almost 85% of equity research reports are based upon a multiple and comparable.
- More than 50% of all acquisition valuations are based upon multiples;
- Rules of thumb based on multiples are often the basis for fina valuation.
“A little inaccuracy sometimes saves tons of explanation”
H.H. Munro
“If you are going to screw up, make sure that you have lots of company”
Ex-portfolio manager.
-> There are four main steps:
- Defining comparable companies;
- Define possible multiple, which means converting assets market values into standardise values (absolute prices cannot be compared);
- Analyse multiple;
- Apply multiples.
1.Define Comparable Companies:
-> COMARABLE FIRM: one with cash flows, growth potential and risk, similar to the firm being valued.
- In this definition there is a component that relates to the industry or sector to which a firm belongs.
- In most analysts fims compared are from the same business.
- Is one of the most difficult tasks.
-> HP: firm in same sector have similar risk, growth and cash flow profiles and therefore can be compared with much more legitimacy.
-> What is meant for…
- Cahs flow: real money the company is generating;
- Growth rate: growth of revenues/ profit/ assets -> Depends on what is most significant for our company to grow;
- Risk: D/E, leverage, ICR.
⚠It’s impossible that two companies have the same for each of these characteristics. We need some thresholds. For this usually we see companies in the same sector: they have similar structure.
-> Steps:
- Identify first the target company’s value drivers (What are the most important things for the company);
- Identify those companies with the same value drivers;
- Define companies’ specificities:
- Sector;
- Geographical Market;
- Presence of divisional structure;
- Size (assets or sales);
- Presence or not of comparative advantages;
- Innovation/development models;
- (Accounting principles)
“In context of valuation equity in firms, the problems [of finding comparable assets] are compounded since firms in the same business can still differ on risk, growth potential and cash flows”
(Damodaran, 2002).
Example: Fincantieri
Sector: construction of big boats and ships. It is very difficult to find comparable companies for diversified businesses because it is difficult to find another company with the same businesses inside.
One of the possible ways is to find 2/3/4 comparable companies for each market. Or we can find companies which are not in the same sector (construction of boats) but are comparable in terms of being system integrators, revenues, D/E, etc. for example airbus and Boeing.
2.Define Possible Multiples:
-> Once comparable companies are identified, need to convert market values into standardise value, since the absolute prices cannot be compared.
-> We define possible MULTIPLES: means converting assets market values into standardized values.
-> Type:
- Asset-Side;
- Equity-Side.
-> CHAR:
- Have short-term nature since they are based on historical data or short term forecasts (may be distorted for long term perspectives).
- Quick method;
- Understanding if company are going in the same direction (not if they are going at the same velocity).
-> Choose multiple based on:
- Objective of Evaluation: we want to identify the EV, we need to use the asset-side multiple, if we want to identify the E, we need to use the equity-side;
- Typology of company: we use the assets-side if the company is producting mainly through its assets, if a company is based on HR or technology (IT companies) we use the equity-side multiple.
-> We can create whatever multiple we want but we need to follow some rules to avoid over or under evaluationg.
Asset-Side: Enterprise Value
- E = EV – Net Financial Position (this last are the debt holder);
- E: market capitalisation;
- NFP: (long-term + short-term debts) – available cash.
- EV = E + NFP
- M&A we are asking the enterprise value because you don’t buy the equity side only (and it would be 0).
- EV multiples…
- Takes as reference (numerator) Enterprise Value of comparable companies.
- Use a parameter (denominator) coherent to an enterprise value perspective.
- To be used for manufacturing companies that make significant use of the assets.
-> Examples of Multiples:
- EV/EBIT: for established companies, only when D&A is not important.
– Advantage: focus on operating management
– Disadvantage: it does not consider different choices in Depreciation and Amortization (-> cash)
Good for companies with great assets.
- EV/EBITDA: used for established companies, preferred to EV/EBIT.
– Advantage: good proxy of cash (THE MOST USED!)
– Disadvantage: neglect CAPEX for different industries
- EV/FCFF
– Advantage: is a cash flow
– Disadvantage: less stable than other indicators
- EV/Sales: used for startup & companies at an easly stage or when profitabilityvalues are negative.
– Advantage: if the above multiples are negative, the multiple is meaningless; in those cases an alternative is using sales (so EV/sales is used when companies are not able in the moment to create value, and for example have a negative EBIT).
– Disadvantage: it does not consider profitability (how we are spending to produce, so the costs).
-> Examples Assets-Side:
Equity-Side: Equity Value
-> DEF: take as reference (numerator) the Equity Value of comparable companies:
-> Market capitalization of the company or equally its stock price (P). The market capitalization of the company is given by the price of the stock on the official exchange multiplied by the number of outstanding shares.
- Equity-side multiples use a parameter (denominator) coherent to an equity value perspective!
- To be preferred when comparables have a similar capital structure, as equity side multiples are affected by the capital structure itself.
-> Examples of Multiples:
- P/E (or PE) = Market Price / Earnings = market price per share/ earnings per share (EPS);
– Advantage: affected by depreciation, amortization, profit or loss of discontinued operations.
– Disadvantage: affected by depreciation, amortization, profit or loss of discontinued operations.
- Variables:
- Price: Usually the current price; sometimes, average price over last 6 months or year;
- EPS: Time: most recent final year (currentI), most recent four quarters (trailing), expected in the next fiscal year or next four quarters (leading) some future years.
- PEG: the ratio between the P/E and the earning growth.
-> This allows better considering the forthcoming growth (CAGR) perspectives of the company.
-> Compound Annual Growth Rate:
- P/BV: the ratio between the market capitalization of a company and its Equity (Share Capital + Reserves + Profit (Loss) of the year).
- P/FCFE: ratio between the market capitalization of a company and its FCFE.
-> Example Equity-Side:
3.Analysis of Multiple:
-> Multiples for sectors:
-> Choose the Best Multiple:
- Identify a subset of multiples that are significant from a theoretical point:
- Identify one or more driver that could explain the variance among the multiples of the different comparable companies:
- Abverage;
- Adjust average;
- Standard deviation;
- Check the relation between fundamentals & multiples.
-> Steps for understanding multiples:
- Define the multiple: the same multiple can be defined in different ways by different users.
-> During comparison, if we use multiples of different users, is difficult to understand how the multiples have been estimated.
- Describe the multiple: you have to know what is the cross sectional/ industry distribution of a multiple, otherways is difficult to look at a number and pass judgment on whether it is too high or low.
- Analyze the multiple: we have to understand the fundamentals that drive each multiple and the nature of the relationship between the multiple and each variable.
- Apply the multiple: Define the comparable universe & controlling for differences is far more difficult in practice than it is in theory.
-> Example: Whatsapp Value Drivers:
