Introduction
Another popular stock valuation method is the comparables approach.
With this approach, investors identify a group of publicly traded companies that are similar to the company they are analyzing. Investors then calculate several trading multiples for each company. These trading multiples are calculated by dividing a measure of market price or enterprise value by some operating or financial metric, such as earnings, cash flow, EBITDA, or book value.
Investors then calculate base-value multiples for the peer group. The base value is usually the average or median of the trading multiples. Investors can then determine whether the company they are analyzing appears undervalued, fairly valued, or overvalued relative to the peer group.
Where discounted cash flow valuation attempts to establish a company’s absolute value, the comparables approach establishes value relative to the prices of similar companies. While discounted cash flow valuation is the more theoretically sound valuation method, the comparables approach is a highly useful supplementary measure.
The comparables approach is especially useful because it reflects how the market is currently valuing similar companies. It can also help investors identify situations worthy of further research. However, investors should remember that relative valuation is not the same as intrinsic value. A company can appear inexpensive relative to peers while still being overvalued on an absolute basis.
Determining Comparable Companies
Like many aspects of business valuation, selecting a peer group is highly subjective.
Generally, investors begin by identifying the company’s main publicly traded competitors. Since most companies list key competitors in their annual reports, identifying industry competitors is relatively simple. Investors can also rely on industry classification systems, such as the North American Industry Classification System, or NAICS.
The peer companies should have principal business activities in the same industry as the company being analyzed. A company’s principal business activity is the business line that makes up the majority of the company’s revenue.
Usually, only a few companies will be adequate peers. However, it is better for the investor to have two or three truly similar peer companies than a greater number of dissimilar companies.
Investors should consider several factors when selecting comparable companies, including:
- Industry and business model;
- Revenue sources;
- Customer base;
- Geographic exposure;
- Growth rate;
- Profitability;
- Capital intensity;
- Leverage;
- Size; and
- Cyclicality.
A peer group is rarely perfect. The investor’s task is not to find identical companies, because identical companies usually do not exist. Rather, the task is to find companies that are similar enough to provide a useful basis for comparison.
Calculating Trading Multiples
Investors calculate trading multiples by dividing some measure of price by an operating or financial metric. Investors should use adjusted financial statements for both the company they are analyzing and the companies in the peer group.
The two most common categories of trading multiples are:
- Price multiples; and
- Enterprise value multiples.
Price multiples compare the value of the common equity to measures available to common shareholders. Enterprise value multiples compare the value of the entire firm to operating metrics available to all capital providers.
Investors should be consistent. If the numerator reflects equity value, the denominator should generally reflect a metric available to equity holders. If the numerator reflects enterprise value, the denominator should generally reflect a metric available to all capital providers.
Price Multiples
The three most common price multiples are:
- Price-to-earnings;
- Price-to-cash flow; and
- Price-to-book value.
Each of these multiples compares the market value of the company’s common equity to a measure related to earnings, cash flow, or accounting book value.
Price-to-Earnings
The price-to-earnings ratio, or P/E ratio, is the best-known price multiple.
To calculate a simple P/E ratio, investors divide the stock price by the company’s trailing earnings per share. Trailing earnings are usually based on the most recent four quarters of earnings.
P/E Ratio = Stock Price ÷ Earnings Per Share
The company’s earnings per share, or EPS, is the company’s net income available to common shareholders divided by the number of outstanding common shares.
The number of outstanding shares used in the EPS calculation should reflect the potential for dilution due to employee stock options, restricted stock units, convertible securities, and other instruments that may increase the number of outstanding shares. Investors can generally find basic and diluted share counts in the company’s most recent quarterly or annual filing.
Investors should be careful when analyzing companies with convertible securities. If conversion is assumed in the share count, investors should also treat the related debt, preferred stock, interest expense, dividends, and other claims consistently. Otherwise, the valuation can mix inconsistent assumptions.
Most financial data services present a company’s P/E ratio. However, investors should be cautious when using published P/E ratios. Accounting profits rarely reflect economic reality without adjustment. Investors are better off using normalized earnings for both the company they are analyzing and the companies in the peer group.
Normalized earnings represent a better estimate of a company’s average long-term earnings power.
Investors generally view P/E ratios in two ways.
First, the P/E ratio states the number of dollars investors are currently paying for every dollar of the company’s earnings. A company trading at 15 times earnings is priced at $15 for every $1 of earnings.
Second, investors can calculate the earnings yield by taking the inverse of the P/E ratio.
Earnings Yield = Earnings Per Share ÷ Stock Price
In other words, where the P/E ratio is the stock’s price divided by normalized earnings per share, the earnings yield is normalized earnings per share divided by the stock’s price.
A company with a P/E ratio of 15 is said to trade at 15 times earnings with an earnings yield of:
1 ÷ 15 = 6.67%
The earnings yield allows investors to make a rough comparison between the company’s stock and income-yielding assets such as bonds or commercial real estate.
Investors view the P/E ratio in relation to the company’s expected future earnings. Investors will pay a high multiple of current earnings if they expect a high rate of growth in future earnings. Investors should keep this relationship in mind when comparing P/E ratios across companies.
A low P/E ratio is not necessarily attractive. It may signal that the market expects earnings to decline or that the company’s earnings quality is poor. A high P/E ratio is not necessarily irrational. It may reflect a business with durable growth, high returns on capital, and predictable earnings.
The investor’s task is to determine whether the multiple is justified by the company’s fundamentals.
Price-to-Cash Flow
Unlike accounting earnings, which reflect accrual accounting and noncash charges, cash flow measures the cash generated by a business.
Investors generally use two measures of cash flow when calculating price-to-cash-flow ratios:
- Operating cash flow; and
- Free cash flow.
Operating cash flow is found on the statement of cash flows and represents the cash generated by the company’s normal business operations. Free cash flow generally represents operating cash flow minus capital expenditures, although investors may make additional adjustments depending on the business.
Investors should rely on adjusted cash flow numbers when calculating price-to-cash-flow ratios. Reported operating cash flow may include temporary working capital benefits, unusual items, or classification issues that distort the company’s recurring cash-generating ability.
Investors can calculate cash flow per share by dividing either operating cash flow or free cash flow by the number of diluted shares outstanding.
Price-to-Cash Flow = Stock Price ÷ Cash Flow Per Share
Like P/E ratios, investors view price-to-cash-flow ratios as both multiples and yields. Because cash flow divided by price provides the cash yield, some investors view this ratio as a better basis of comparison with income-generating investments.
Free cash flow is often more useful than operating cash flow because it accounts for the capital expenditures required to maintain or grow the business. However, investors must be careful. A company can temporarily improve free cash flow by underinvesting in the business, reducing inventory, delaying payments, or cutting necessary maintenance capital expenditures.
Cash flow is important, but cash flow quality is just as important.
Price-to-Book Value
The price-to-book value ratio compares the stock’s price to the accounting value of a company’s common equity.
Investors calculate the P/BV ratio by dividing the stock price by shareholders’ equity per share.
Price-to-Book Value = Stock Price ÷ Book Value Per Share
Book value per share is shareholders’ equity divided by the number of outstanding common shares.
The P/BV ratio has several major drawbacks.
First, historical cost accounting for long-term assets means that appreciating assets, such as real estate, may be carried on a company’s balance sheet at prices that significantly understate their market value.
Second, companies that have grown through acquisitions may have significant accounting goodwill, while companies that have grown internally may have valuable internally generated intangible assets that do not appear on the balance sheet. As a result, book values can differ significantly even when two companies have similar economic characteristics.
Third, book value often fails to capture the value of brands, customer relationships, software, data, research capabilities, distribution networks, and other economically valuable intangible assets.
For these and other reasons, comparisons of book value are often meaningless.
For some industries, however, book value can be a useful multiple. For financial firms, such as banks and insurance companies, whose assets are largely composed of financial securities, loans, and other financial instruments, book value may be a reasonable proxy for underlying net asset value.
Even in financial industries, however, investors should analyze asset quality, reserve adequacy, unrealized gains and losses, interest rate sensitivity, and leverage. Book value is a starting point, not a conclusion.
Enterprise Value Multiples
Enterprise value multiples allow comparison of companies with different capital structures.
Enterprise value multiples use the market value of the firm’s capital in the numerator and an operating metric in the denominator. These multiples are especially useful because they focus on the value of the entire business rather than only the value of the common equity.
Common enterprise value multiples include:
- Enterprise value-to-EBITDA;
- Enterprise value-to-EBIT;
- Enterprise value-to-revenue; and
- Enterprise value-to-free cash flow.
The usefulness of each multiple depends on the company, industry, and quality of the underlying metric.
Calculating Enterprise Value
Enterprise value, or EV, provides an estimate of the market price an acquirer would have to pay to acquire the entire company, before considering transaction-specific matters.
A useful enterprise value formula is:
Enterprise Value = Market Value of Equity + Debt + Preferred Stock + Noncontrolling Interests + Debt-Like Claims – Cash and Cash Equivalents
Investors may also adjust enterprise value for outstanding stock options, restricted stock units, convertible securities, underfunded pensions, lease obligations, contingent liabilities, and other claims depending on the purpose of the analysis.
The market value of common equity, also called market capitalization, is the aggregate market value of the company’s common stock. Investors calculate market capitalization by multiplying the current stock price by the number of outstanding shares.
Market Capitalization = Stock Price × Shares Outstanding
Debt should include contractual financing sources such as outstanding bank loans, bonds, short-term notes, and other debt-like obligations. Under current lease accounting rules, many leases are recognized on the balance sheet as right-of-use assets and lease liabilities. Investors should therefore review lease liabilities and determine whether they should be treated as debt-like obligations when calculating enterprise value, leverage, and comparable multiples.
Generally, only a portion of a firm’s debt will have available market quotations, so investors will often use accounting values for non-publicly traded debt. Investors must also include the value of outstanding preferred stock, using market values when available.
Noncontrolling Interests
When a company controls a subsidiary for which it owns less than 100% of the outstanding stock, the parent company must generally consolidate the accounts of the subsidiary with its own.
The parent company presents as a separate line item the portion of the subsidiary’s income attributable to outside shareholders. These outside shareholders are generally referred to as holders of noncontrolling interests.
Similarly, the parent company presents the portion of the subsidiary’s equity belonging to outside shareholders in the equity section of the parent company’s balance sheet.
Since the operating metric in the denominator of an enterprise value multiple usually reflects fully consolidated earnings, investors include a value for noncontrolling interests in enterprise value. Investors can either use the book value of noncontrolling interests from the balance sheet or calculate a value by applying a multiple to net income attributable to noncontrolling interests as sourced from the income statement.
The key principle is consistency. If the denominator includes consolidated operating earnings, the numerator should include the value of claims on those consolidated earnings.
Stock Options, Convertible Securities, and Dilution
Investors should also account for claims arising from employee stock options, restricted stock units, performance shares, convertible securities, and other potentially dilutive instruments.
Some investors do this by calculating equity values using fully diluted shares outstanding. This can be appropriate, but it may introduce complexity, especially when convertible securities are involved. If conversion is assumed, the investor may need to adjust debt, preferred stock, interest expense, dividends, share count, and other related items.
Investors should avoid double counting. For example, they should not both add the value of an option claim to enterprise value and also fully reflect the same option in diluted shares in a way that counts the economic claim twice.
Public company filings often provide helpful disclosure on basic and diluted EPS, share-based compensation, options, restricted stock units, and convertible instruments. Investors should read the footnotes carefully and treat these claims consistently in both enterprise value and per-share calculations.
Finally, investors should subtract cash and equivalents. Enterprise value represents the value of the operating business, net of excess cash. A theoretical acquirer could use the company’s cash to pay down debt or help fund the purchase price.
However, not all cash is necessarily excess cash. Some companies require substantial cash balances to operate. Financial companies, insurance companies, regulated entities, and businesses with international operations may require more nuanced treatment. Investors should use judgment when deciding how much cash should be subtracted.
Operating Metrics for Enterprise Value Multiples
After calculating enterprise value, the next step is to determine the relevant operating metric to use in the denominator.
Although investors may use numerous operating metrics, two of the most common are:
- Earnings before interest, taxes, depreciation, and amortization, or EBITDA; and
- Free cash flow to the firm.
EBITDA is calculated using income statements from the company’s most recent four quarters. As with all operating metrics, investors should use adjusted numbers.
EBITDA allows for comparison of firms with different capital structures and depreciation and amortization policies. Although enterprise value-to-EBITDA is the most widely used enterprise value multiple, EBITDA is a flawed measure of operating earnings because it ignores a company’s investments in working capital and fixed assets.
For many investors, a better operating metric is free cash flow to the firm. Free cash flow to the firm accounts for investments in working capital and fixed assets and thus represents the residual cash available to the firm’s capital providers.
EV/EBITDA = Enterprise Value ÷ EBITDA
EV/Free Cash Flow = Enterprise Value ÷ Free Cash Flow to the Firm
Unlike stock price multiples, which directly calculate a firm’s equity value, enterprise multiples value the entire firm. Investors must calculate the equity value by applying the base multiple derived from the peer group to the operating metric and then subtracting non-equity claims. Investors then calculate the per-share value by dividing the equity value by the number of shares outstanding.
Applying Peer Multiples
Once investors have selected a peer group and calculated the relevant trading multiples, they must decide which multiple or multiples are most useful.
This decision requires judgment. A business with stable earnings may be well suited for P/E analysis. A capital-intensive business may require closer attention to free cash flow. A company with different leverage from its peers may be better analyzed using enterprise value multiples. A financial company may require price-to-book value or price-to-tangible-book value analysis.
Investors often calculate several multiples and compare the results. The purpose is not to mechanically average every output. The purpose is to understand how the market values similar businesses and whether the company being analyzed appears attractively priced after adjusting for differences in quality, growth, profitability, leverage, and risk.
For example, a company may trade at a lower EV/EBITDA multiple than its peers. This may suggest undervaluation. But the lower multiple may also be justified if the company has lower margins, weaker growth, more leverage, poorer management, inferior returns on capital, or greater customer concentration.
The comparables approach is most useful when investors understand why a multiple differs.
Shortcomings of the Comparables Approach
Because the comparables approach measures the relative value of a security, it can understate or overstate a stock’s value on an absolute basis.
In other words, relative valuations can be misleading when the market is overpricing or underpricing an entire industry. This risk is especially pronounced when the market or a segment of the market is overpriced. In this case, concluding that a stock is cheap on a relative basis can still expose the investor to a significant risk of loss.
Another shortcoming is that accounting for differences in growth and profitability among comparable companies is highly subjective. No two companies are identical. Differences in margins, capital intensity, balance sheet strength, accounting policies, reinvestment opportunities, management quality, and competitive position can all justify different valuation multiples.
The comparables approach also depends heavily on the quality of reported financial data. If earnings, EBITDA, book value, or free cash flow are distorted by nonrecurring items, acquisition accounting, unusual working capital movements, or aggressive accounting estimates, the resulting multiples may be misleading.
Despite these shortcomings, the comparables approach is a widely used method of stock valuation. Investors can increase the reliability of comparables valuation by using this approach to supplement discounted cash flow valuation. Investors can also create a range of values by using different scenarios that affect the underlying operating metrics.
Conclusion
Although the comparables approach is a less theoretically sound method of equity valuation than discounted cash flow valuation, it is a useful supplementary method.
Because of the relative simplicity of the calculations, the comparables approach is highly useful for identifying companies worthy of further analysis. It can help investors understand how the market is valuing similar businesses and whether a company appears inexpensive or expensive relative to its peers.
However, relative valuation should not replace independent judgment. A company may be cheap for a reason. A peer group may be overvalued. A multiple may be distorted by accounting differences or temporary earnings conditions.
The best use of market comparables is as part of a broader valuation process. Investors should combine relative valuation with fundamental business analysis, financial statement analysis, discounted cash flow valuation, and a margin of safety.
Sources
Pinto, Jerald E., Elaine Henry, Thomas R. Robinson, and John D. Stowe. Equity Asset Valuation, 3rd ed. Hoboken: Wiley, 2015.
Rosenbaum, Joshua, and Joshua Pearl. Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions, 2nd ed. Hoboken: Wiley, 2013.
