A comparable company analysis (CCA) is a common valuation method in investment banking that uses the market prices and financial ratios of similar firms to estimate the value of a target company. In this article, you will learn what are the key multiples used in a CCA and how to apply them in practice.
Multiples are ratios that compare the market value of a company or its equity to a financial metric, such as earnings, sales, or assets. Multiples can be classified into two types: enterprise value multiples and equity value multiples. Enterprise value multiples use the total value of the firm, which includes both debt and equity, as the numerator. Equity value multiples use only the value of the shareholders' stake, which excludes debt, as the numerator. The denominator can be either a historical or a forward-looking measure of performance, such as EBITDA, EPS, or revenue.
Comparable Multiples are a good benchmark to establish Fair Value/ Fair Market Value. However, applying the right multiples is where the valuation skills of a professional come into play. Firstly, the expert’s judgment in choosing the appropriate comparable companies is important. Often private companies maybe in more niche markets or less diversified than their public peers. This is where meaningful discussions with Management and industry knowledge of the expert help to discern which public companies are appropriate comps. The second step is selecting the right multiples - while Revenue, EBIT, EBITDA metrics are more commonly used, for pre-revenue, and e-comm companies other metrics like number of customers, and KPIs can be helpful.
The right metric depends on the industry. Most industries use a EV / EBITDA multiple. This comes closest to a normalized capital structure independent valuation multiple. EV / EBITDA isn't the best metric when EBITDA is negative, or at financial companies. For financial companies, price to book is the better metric. REITs generally use price to funds from operations (FFO).
Multiples: A Finer Look In finance, multiples offer insights into a company's valuation by juxtaposing its market value with distinct financial benchmarks, such as earnings or assets. These can be bifurcated into two categories: enterprise value and equity value multiples. The former encompasses the company's entire valuation, including both equity and debt. In contrast, the latter concentrates solely on shareholder equity, omitting debt. The denominator, forming the base of these ratios, can be historical or predictive metrics, with EBITDA, EPS, or sales being typical examples. This offers a robust lens for evaluating relative market worth.
In valuation multiples are ratio's that can be used to quickly estimate the value of a company. The most commonly used is the EBITDA multiple, which calculates the Enterprise value of a company in multiples of its EBITDA. If EBITDA multiples are known for valuations of comparable companies, this multiple can be applied to estimate the value of your target company. Note however, that using multiples in valuation is a relatively crude approach, as each company is unique in terms of positioning, market position, growth / outlook, capital structure, etc.
Multiples are a good way to price a company relative to its peer company. To find a peer company, the target should have a similar growth, debt profile, business model etc. To choose the multiple, business expertise is needed. For e.g. banks, financial institutions and manufacturing may use P/B where a service-based business such as IT may use P/E. There can also be ratios that may not be well known as Price/No. of users.
Multiples are widely used in a CCA because they are simple, intuitive, and easy to calculate. They can also provide a quick and reliable estimate of the value of a company based on the market prices of its peers. Multiples can also capture the market sentiment and expectations of the industry and reflect the growth potential and risk profile of the company. However, multiples also have some limitations, such as being sensitive to outliers, accounting differences, and cyclical factors. Therefore, multiples should be used with caution and complemented by other valuation methods, such as discounted cash flow or precedent transactions.
Contexts matter. In frontier markets like Iran the key metrics for retail investments are P/E and P/S ratios. The ratios which includes balance sheet items like book value are not deployed in the valuation exercises because high, sustainable inflations causes huge divergence between BV and their current value.
The first step in a CCA is to identify a set of comparable companies that have similar business models, products, markets, and growth prospects as the target company. The selection of comparable companies can be based on various criteria, such as industry classification, size, profitability, leverage, and growth rate. The goal is to find a group of companies that are as close as possible to the target company in terms of their operating and financial characteristics. However, it is rare to find a perfect match, so some adjustments and judgment may be required.
Comparable companies, or a so called peer-group, can be selected by comparing industry, product offering, profitability, capital structure, etc. When a company is active in multiple markets, it is possible to add comparable companies in each sector and weigh their contribution based on the sales of your target company in that sector. When selecting companies for this purpose however, it is important to select companies that are relatively 'pure play', which means that they are not diversified across markets.
Choosing the right set of comparable companies is paramount when embarking on a Comparable Company Analysis (CCA). The quest starts with pinpointing firms that mirror the target company's landscape—be it in business architecture, offerings, market footprint, or growth trajectory. Criteria for selection can span a broad spectrum, from industry delineation and corporate scale to profit margins, financial leverage, and expansion pace. The overarching objective is to curate a cohort of companies that most closely emulate the operational and fiscal nuances of the target entity. Perfection in this endeavor is elusive, necessitating occasional recalibrations and a touch of astute judgment to refine the comparables list.
The next step in a CCA is to calculate the multiples for each comparable company using the market data and financial statements. These can be sourced from Bloomberg, Yahoo Finance, Capital IQ, annual reports, 10-K filings, or analyst reports. Common multiples used in a CCA include EV/EBITDA, which measures the value of the firm relative to its earnings before interest, taxes, depreciation, and amortization. EV/Sales captures the growth potential of the firm by measuring its value relative to its revenue. P/E is one of the most popular and widely used multiples because it reflects the market's expectations of future earnings. Finally, P/B is often used for valuing financial firms because it indicates the return on equity of the firm.
When employing multiples for valuation, particularly EBITDA multiples, it's crucial to contextualize them with comparable transactions or valuations, recognizing the disparity between private SMEs in Europe and public US firms. Ensuring the EBITDA reflects future projections is vital, as is a thorough understanding of its components. This includes making necessary normalizations to represent the true economic performance, offering a more accurate and tailored valuation relevant to the specific market and company scale.
The final step in a CCA is to apply the multiples to the target company to derive its implied value. This can be done by taking the average, median, or weighted average of the multiples of the comparable companies and multiplying it by the relevant metric of the target company. For example, if the average EV/EBITDA multiple of the comparable companies is 10x and the target company's EBITDA is $100 million, then the implied enterprise value of the target company is $1 billion. The implied equity value can be obtained by subtracting the net debt from the enterprise value. The implied value can also be expressed as a range by using the minimum and maximum multiples of the comparable companies.
The interpretation of multiples depends on the context and the purpose of the valuation. Generally, a higher multiple indicates a higher value and a lower multiple indicates a lower value. However, a higher multiple can also imply a higher growth rate, a lower risk, or a higher quality of the firm. Similarly, a lower multiple can also imply a lower growth rate, a higher risk, or a lower quality of the firm. Therefore, it is important to understand the drivers and assumptions behind the multiples and compare them with the target company's characteristics. It is also helpful to perform a sensitivity analysis and a scenario analysis to test the robustness and reliability of the multiples.