The comparable model is a relative valuation approach. The basic premise of the comparables approach is that an equity’s value should bear some resemblance to other equities in a similar class. For a stock, this can simply be determined by comparing a firm to its key rivals, or at least those rivals that operate similar businesses.

There are two primary comparable approaches. The first is the most common and looks at market comparables for a firm and its peers. Common market multiples include the following: enterprise value to sales (EV/S), price to earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF). To get a better indication of how a firm compares to rivals, analysts can also look at how its margin levels compare.

The second comparables approach looks at market transactions where similar firms, or at least similar divisions, have been bought out or acquired by other rivals, private equity firms or other classes of large, deep-pocketed investors. Using this approach, an investor can get a feel for the value of the equity being valued. Combined with using market statistics to compare a firm to key rivals, multiples can be estimated to come to a reasonable estimate of the value of a firm.

It is important to note that it can be difficult to find truly comparable companies and transactions to value an equity. This is the most challenging part of a comparables analysis.

In this post we review the steps for the first approach which is based on applying some ratios or multiples from peer companies to some key financials statics of the company being valued  giving as a result a range of valuation.

Following the steps to apply methodology:

1. Analyzing the target company

This step is crucial in order to select comparable companies with good judgment. The analyst  should take into account aspects such as: the company´s activity, the products it manufactures, the market segments and geographical markets in which it operates, the nationality, the strategic business units, the ownership structure, its competitive situation in the market (power of  suppliers, consumers, legal regulations, etc.) and the organizational structure and quality of its management, among others. The more we know about the company that is being valued, more rational criteria can be considered in the valuation process.

2. Identifying comparable companies.

A key aspect in applying this methodology is the selection of the companies with which the company being valued will be compared. They must be listed companies and in the same sector as the target company. The most relevant aspects to consider are: business and product mixes, similar market segments, size in revenues or in profits compared to the target company, organizational structures, costs and expenses similar to the company being valued and expectations of growth and profitability similar to the target company, among others. In practice it is difficult to find companies that comply with all the previous aspects, due to that sometimes is necessary to extend the scope of selection of comparable companies to have a significant number of companies in the analysis. For example, companies in the food sector will be taken to analyze a company dedicated to the manufacture and marketing of cereals.

Regarding the number of companies to be included in the analysis it will depend on the sector being analyzed, the availability of information and the similarities of those chosen to compare to the target company. The experts recommend no less than ten companies if possible and if they have significant results, and narrow the analysis according to the most significant comparable aspects, to reach a range of two or three companies with which will be obtained the valuation of the target company.

3. Calculating and selecting multiples

The most common multiples used in this methodology are:

EV / Sales  – (Enterprise value / Sales)

This multiple shows how many times the value of it sales is valued a company in the market.

When a company has negative EBITDA or EBIT, multiples such as EV / EBITDA or EV / EBIT are not significant. In these case,  EV / Sales  may be the most appropriate. It is often used in valuations of companies whose operational costs exceed sales, as can be the case with nascent Internet companies, for example. However, it is not very representative in many cases since companies with similar sales may have very different operating margins.

EV / EBITDA – (Enterprise value / Earnings before interest, taxes, depreciation and amortization)

EBITDA is considered a good approximation to the gross cash flow (before investments, financing and taxes) generated by the company and is a ratio widely used in comparable multiples valuations.

It indicates how many times the operating profit, without taking into account fiscal, financing and depreciation policies, is valued a company . Its main advantage is that it is a good indicator of the costs and expenses structure of a business sector no matter of its geographical location and that it does not take into account financing decisions or fiscal issues.

EV / CFO – (Enterprise value / Cash flow from operations)

CFO is calculated as EBITDA less the change in working capital investment and CAPEX. This ratio, in case of all the data for its calculation be available, is one of the most representative to estimate the value of the company since it shows how many times the cash flow generated by operations is valued that company; Among its disadvantages are that the application of the ratio in companies with high growth can lead to negative results.

EV / BV  – (Enterprise value / book value)

Indicates how many times the equity value is valued a company. It is a useful multiple in capital intensive companies. However, there may be differences in the accounting of certain liabilities as capital and vice versa that make comparison with peer companies difficult.

4. Applying multiples to the target company

In this step the comparable multiples are applied to the key financial data of the target company to calculate its business value. It is recommended that the range of multiples obtained be applied to: a) historical financial data of the target company as: EBITDA, CFO, Sales, Equity of the last fiscal year and  b) projected data of the target company that usually prepares the company or its analysts.

5. Valuing the target company

Prepare a table with all the values calculated and limit the values selected within a range of values. In the end, we should be able to justify the results through our own criterion, clearly establishing the reasons for the selection of comparable companies and the similarities currently or expected with the target company.

The multiples comparable method is a useful tool if it is correctly applied since it incorporates the investors’ expectations about the future performance of the industry in which the company is being valued and is a simple and widely used methodology for valuing companies in the market.

This post is based on “Equity Valuation: The comparables approach” as well as on some articles from IESE´s Professor Pablo Fernandez.