The principle behind trading comparables is that similar businesses can be used as a market benchmark to establish a valuation range for a corporation. The comparables share key markets, growth prospects, operational drivers and risks. Key metrics (both operational and valuation) are calculated for the peer group and used to extrapolate the value of the business being considered.
Trading comparable companies analysis provides a current valuation based on prevailing market sentiment. As a consequence, it may be more relevant than intrinsic tools such as DCF. However, traded prices can be subject to periods of extreme volatility (or even irrationality) which affects the valuation. No two businesses are exactly the same so the degree of comparability of the peers is always subjective.
More than one valuation technique should be used in order to inform the analysis. A wide divergence between the answers from the different valuation techniques means the assumptions and key calculations should be checked thoroughly.
Choose comparables companies
The starting point for selecting the peer group is to understand the business being valued. Companies in the peer group should be as similar to the valued company as possible.
Calculate Equity and Enterprise Values
For trading comparables, the enterprise value calculation may include the following components:
Net debt is interest-bearing liabilities less highly liquid financial assets. For valuation purposes, the net debt should be included at market value.
Practitioners use the latest balance sheet value as a proxy for market value. This is a reasonable approach in most cases since the value of debt is unlikely to change significantly unless there is a decline in issuer credit quality or a dramatic change in interest rates. Pensions, leases, NCIs, preferred stock and debt-like items pose extra challenges and need to be dealt with carefully.
Calculate Value Drivers
An appropriate value driver should be used in order to best understand the business and its valuation. The most common are revenues, EBIT, EBITDA and EPS.
Calculate Multiples and Other Statistics
Once the values and the valuation drivers have been calculated, the analyst will calculate the multiples in a comps sheet.
In addition, the output includes a series of metrics that help inform the understanding of the sector, the players, and the business being valued.
Interpret the Output and Select a Valuation Range
There are no hard and fast rules about how to interpret the output of the trading comparables analysis. Experience is significant but in all cases the better the weight of evidence the better the valuation.
Have you read ‘Calculating Valuation Multiples‘ yet?