Relative or Comparable Valuation
Relative or Comparable Valuation
Relative or Comparable Valuation
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Table of Contents
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Comparables / Relative Valuation / Trading Comparables / Comps / CompCo is a method of valuing companies under which Value is derived based on a comparison of Multiples within a set of peers under current market conditions.
Concept
The Classic Question:
Is a low P/E better or a high one? Most would say the former! However, that may not always be correct. The answer lies in a Comparable Analysis which helps figure out whether the higher P/E stock is overvalued or valued highly as a result of superior expected performance! Among other things, a Comparable Analysis aims to determine fair value based on current & expected fundamental performance, Intangibles like quality of management, brand value, market share and track record in terms of TRS Total Return to Shareholders. Stocks trading at a higher multiple usually tick mark one or more of the above conditions
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Captures Market Sentiment Works best in the short run (between quarterly results) Quick & easier to apply & explain than fundamental approaches like DCF More relevant when inflow/outflow of funds changes or is expected to change significantly Very popular among Investment Banks, Brokerage houses & Mutual Funds. Implying that this is one of the ways in which the majority decide fair value (for the short run)
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In the real world it is very difficult to find comparable companies Myopic - Focus on quarterly results rather than the long term Fair Value based on peer comparison may imply that exuberance will always result in biased valuations irrespective of Intrinsic value Many Analysts use Comps in the down cycle while using DCF in the upturn. Indicating that Comps are likely to under value stocks when fundamentals are in the up cycle and vice-versa 1
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The process of Comparable Valuation is fairly uncomplicated. It is a mix of both art & science. The Science lies in calculations and determining which company should command a higher value while determining fair value is an art
Step 1
Identifying the Comparable Universe The Industry or Sector may not be comparable as a result of different products & markets implying different fundamental performance and hence different valuation. It is for this reason that one must look at the Sub-Sector. E.g. Industry > Metals Sector >Alloys Sub Sector > Non Ferrous Alloys
Step 2
Spreading Comps Making calculations > Margins & Ratios > Last Twelve months > Fully Diluted shares > Enterprise Value > 3yr CAGR sales & PAT Equity Multiples > P/E, PEG, P/B, P/FCFE Enterprise Multiples > EV/Sales, EV/EBITDA, EV/EBIT, EV/FCFF Sector Specific Multiples > EV/EBITDAR, EV/Ton, EV/Subscriber, EV/Plane, EV/Employee, EV/branch
Step 3
Benchmarking Companies with Similar Sales, Market cap, Margins and other Performance Metrics must be indentified to determine closest comparable companies and thus benchmark them against the company in question
Step 4
Determining Fair Value Benchmarking would help arrive at a range of multiples. Average & Median Multiples of such companies would help determine the fair value of the company in question while Highest & Lowest Multiples will serve to determine a range
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Calendarization
Company results are always reported as per Fiscal year (FY) ended as decided by the management. In India, it is usually 31-Mar. A Calendar year CY (Jan-Dec) is way of re-basing companies that have different fiscal years. The process is called Calendarization. The issue starts with Financial Projections itself which are made on FY basis so as to make it comparable to what the company will report in future. The only way to make it comparable to other companies that have different Fiscal Years is to calendarize (restate in Jan-Dec terms) add quarterly results and subtract corresponding quarters, like LTM. However, in case of Annual Forecasts one may need to proportionally alter it.
E.g. If Company A has a FY of 31-Mar. Sales for FY 2009 are Rs.1,200Crs while that of FY 2010E are Rs.1400Crs CY2010E Sales = (3/12*1200) + (9/12*1500) = Rs.1350Crs (Sales from Jan-Dec 2010)
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Items to be adjusted
Although one may have to make more adjustments than the ones mentioned, below are a few general guidelines
> Extraordinary Gains/Losses/write ups/write downs Such items are non-recurring in nature and typically related to Foreign Exchange, one time write ups/downs, losses due to strikes/lock-outs etc. Such losses must be added back and a reverse treatment of such gains must be made > Accounting anomalies1 Inventory adjustments LIFO to FIFO Deferred taxes The most popular accounting shenanigan used by companies to smoothen income Leases A capital cost and hence should be excluded from EBIT to reflect true Operational or Asset Efficiency Capitalizing vs Expensing This can have a significant impact on earnings and hence distort related multiples.
1Discussed in
Classroom
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Example
CMP INR 345
No. of Weighted ITM Proceeds Options Avg. Strike Options from Treasury (in Lacs) Price (in lacs) Conversion Stock 4,325 INR 238 4,325 1,029,350 2,984 6,236 INR 267 6,236 1,665,012 4,826 8,793 INR 290 8,793 2,549,970 7,391 2,465 INR 356 0 0 0 8,576 INR 390 0 0 0 No. of Shares 19,354 15,201 O/S Shares Add ITM Options Less Treasury Stock Fully Diluted Shares 1,987,653 19,354 15,201 1,991,806
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Visual Explanation
Minority Interest
Other Non Equity Claims ST& LT Debt Less Excess C&CE
Enterprise Value
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All performance measures must be calculated as LTM along with Last 3 year & forward 3 year Average
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LTM ended 8th-Apr-10 Other Total Operating Operational Sales Income Revenues EBITDA D&A 8,421 19,653 6,926 3,694 2,114 7,001 3,493 2,865 1,742 1,414 173 109 34 25 66 16 11 8,594 19,653 7,035 3,728 2,139 7,066 3,509 2,876 1,742 1,414 2,571 5,895 1,928 963 602 2,169 1,515 1,305 481 335 342 962 282 225 128 379 347 182 68 73 all figures in Rs. Crores ExtraReported Other ordinary Adj.s EBIT PAT Income Items to PAT Adj. PAT 2,229 4,933 1,646 738 474 1,790 1,169 1,123 412 262 1,546 2,809 1,226 410 179 1,174 983 398 242 228 106 255 150 3 (26) 58 60 8 3 12 (45) 106 255 150 3 (26) 58 15 8 3 12 1,440 2,554 1,076 407 205 1,116 968 390 239 216
EV calculation all figures in Rs. Crores ConPref vertible Enterprise Capital Debt C&CE Value 984 113 881 85 55 104 472 39 125 327 17,104 27,307 20,483 6,202 4,552 16,486 8,707 5,881 1,881 1,330
Company Name ACC Grasim Gujarat Ambuja India Cements Dalmia Cement Ultratech Cement Shree Cement Madras Cement JK Cements JK Lakshmi Cements
Market Cap 17,270 23,161 20,713 4,025 2,040 13,726 7,684 2,966 1,342 919
Net Debt
STD
Minority LTD Interest 450 3,395 166 1,988 2,338 2,142 1,496 2,463 564 703 -
(166) 368 4,146 2,177 2,512 2,760 1,024 2,915 540 411 864 274 229 723 490 101 35 (229) 486
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15 Day Financial Modeling & Equity Valuation Comparable Valuation Comparable Valuation | Output Sheet Snapshot - Output Sheet
3 yr CAGR Capacity (in Crore tons per annum)
2.263 4.880 2.200 1.295 0.900 2.190 0.683 1.100 0.750 0.475 -
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Promoter Stake
LTM Margins
Company
CMP
52 week Low
365.00 872.00 56.00 45.00 67.20 678.00 320.00 55.25 31.25 31.00 -
Sales PAT
31-Mar-09 EBITDA
EBIT
PE/G
ACC Gra s i m Guja ra t Ambuja Indi a Cements Da l mi a Cement Ul tra tech Cement Shree Cement Ma dra s Cement JK Cements
46.21% 25.50% 46.00% 27.37% 56.60% 54.78% 65.56% 42.00% 69.78% 44.48%
30% 30% 27% 26% 28% 31% 43% 45% 28% 24%
26% 25% 23% 20% 22% 25% 33% 39% 24% 19%
11.2x 8.2x 16.9x 9.8x 11.4x 11.7x 7.8x 7.5x 5.5x 4.0x
12.0x -323.0x 9.1x 19.2x 10.0x 12.3x 7.9x 7.6x 5.6x 4.3x 37.7x 617.3x 54.8x 19.6x 3.7x 11.5x 8.9x 8.9x
9.9x -294.4x
59% 216%
Medi a n Avera ge Ma x Mi n
22% 27% 8%
59% 216%
4.3x -323.0x
Note: The output sheet must also include Forward multiples based on Consensus Estimates as discussed in Slide 9.
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In most cases DCF & Comps are complimentary i.e. one provides a sanity check to the other! However, in times of conflict it is better to rely on DCF. This is because Comps do not attempt to arrive at Intrinsic value, implying that the market could easily stretch valuations based on Comps. This is because one cannot substantiate whether Infosys is correctly trading at an Earnings multiple of 35x unless one can test it through at least one or more methods that Value a company based on its Fundamentals. DCF ties Stock Value to fundamentals whereas Comps are driven by Sentiments & Consensus Estimates! This also implies that when more money chases few stocks they are driven primarily by demand-supply gap rather than fundamentals ! In such times the broader market relies on Comps rather than DCF. DCF Value is driven by Fundamental performance which does not change drastically between two quarters. However, Multiples change every second indicating a very short life. Hence, Comps are better suited between quarters while DCF should be relied upon for a longer horizon say >1 year
Typically Average of LTM multiples of closest comparable companies are multiplied by the Consensus Estimate of the appropriate fundamental metric (the denominator). E.g. Average of LTM adjusted P/E of closest comparable companies is 10x and Consensus estimate of adjusted EPS for next year is Rs.12 implying a forward price of Rs.120 (=10 x 12)
Although there are several formulas available to Forecast Multiples. The analyst typically divides Current Market Cap or Enterprise value by the appropriate consensus estimate. E.g. Current Share Price is Rs.100 and Consensus EPS estimate is Rs.25, implying that Forward P/E is 4x (=Rs.100/25). 14
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Consensus Estimates are Average (or Median) estimates for fundamentals or Multiples across the entire universe of estimates for a given company. These are made available at Bloomberg, Thomson-Reuters, Zacks, Yahoo Finance, Google Finance etc.
Unlike DCF, the Comparable approach aims to capture market sentiment. Among other things market sentiments are driven by Consensus Estimates and hence they primarily drive multiples.
Fiscal Year (FY) data may be older by a quarter or more. Implying that it is stale and does not influence current traded multiples/prices. Calendar Year (CY) data is used to re-base companies with different FY endings. E.g. Companies with Mar, Sep, Dec ended results can only be compared if they have a common base i.e. Jan-Dec
Why Calendarize ?
Non-Recurring items like Other Income, Extraordinary gains/losses and other one time items cannot be forecasted with reasonable accuracy and should be excluded since they distort Value. Such gains should be subtracted and losses be added back to reflect sustainable income.
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Diluted Shares are calculated to reflect maximum possible no. of shares coming into the market as a result of conversion of debt, warrants & ESOPs. Such dilution is a threat to existing shareholders as their stake gets diluted and hence will reduce Share Price. The Treasury Stock Method (TSM) is the most popular approach used. It assumes that proceeds from all In-The-Money (ITM) options are used to buyback shares so as to minimize dilution
What factors/metrics are used to arrive at the closest comparable companies ? How does one determine a Fair Value range
To start with, when possible one should look at the Sub-Sector and not Sector or Industry. Within that, one should look at companies with very similar products/product mix. Secondly, Sales should be given more weight than Market Cap else valuation will result in circular reasoning. Thereon, one may use Geographic presence, Degree of Revenue Concentration, Capacity, Margins, ROCE & ROE, Leverage ratios etc. to arrive at the tightest range of companies.
Once the process of benchmarking has been carried out one may use the Min & Max of the tightest range to determine a Fair Value range
A negative P/E indicates that EPS is negative (loss making company). EV can be negative when the cash component is relatively higher than Debt + Market Cap. Negative EVs usually occurs in times of Exuberance i.e. when markets crash and Market Value goes below fair value. A negative EV can be seen in the BFSI sector as they are cash rich and during bearish phases they may trade well below their fair value. In both the above situations one may use P/B as it is more stable. However, for startups or companies that have accumulated losses even P/B will be negative! 16 In such extreme situations one is left with no choice but to use P/Sales!
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Yes. One simply calculate EV and then subtract Net Debt to arrive at Equity value and finally divide it by diluted shares to arrive at Value per share. E.g. Company A has an implied EV/EBITDA of 5.5x and estimated EBITDA of Rs.1000, Current Net debt of Rs.2,500 and 300 diluted shares. Its EV = 5.5 x 1,000 = 5,500 and Equity Value = 5,500-2,500 = Rs.3,000 while Value per share = Rs.3,000/300 = Rs.30 Consolidated Statements represent Sales, EBITDA , EBIT etc. contributed by Minorities as well. If one does not include Minority interest, the Value of the Enterprise will be understated and the firm will appear cheaper than it actually is! Excess Cash (not Operating Cash!) is subtracted as it may be used to pay down debt. In any case, the Cash available is a source and not an application of funds! Ideally, one must use all Cash Equivalents while not including minimum required cash (i.e. Operating Cash) While calculating a multiple the numerator must be consistent with the denominator. EV represents the value created by (or belonging to) the entire firm, hence, the denominator must be an item available for all i.e. Sales, EBITDA, EBIT & FCFF. However, After EBIT all other items like Interest, Preference dividends, Minority interest etc. are payments made to particular claimholders and are hence not available for the entire firm. Therefore, EV/PAT or P/EBITDA are inconsistent. One exception to the rule is P/Sales which is used in the Retail sector! 17
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The most popular multiples are P/E, P/B, EV/EBITDA, and P/CEPS [Cash EPS = (PAT + Dep.)/Diluted Shares] in that order. In the service sector EV/EBITDAR is the norm. Where R indicates rental/lease expense and is a significant expenditure in the sector. It is added back as it is a charge payable to a particular claimholder to fund assets and hence treated as debt. Irrespective of whether a company leases/rents/buys assets its EV will remain same! (Remember: EV is Capital Neutral!) Efficiency in each sector is driven by specific metrics. For e.g. in the Hotel industry EV/EBITDA will not reflect the additional EV created as a result of 500 rooms added. In such cases a sector specific multiple proves superior. EV/room indicates how well has the company used each room to increase Enterprise Value. Secondly, it acts as an indicator of premium/discount over liquidation cost. E.g. if a room costs Rs.5Lacs to build and a company has 10,000 such rooms its liquidation value is Rs.500Crs (although it is just a ball park number!)
Sector Healthcare Hospitality Retail Telecom IT & ITES BFSI Recommended Multiple EV/Bed EV/Room EV/Sq.ft & P/Sales EV/Subscriber EV/Employee P/B
1Although the
Sector Airlines
Recommended Multiple EV/Plane or EV/Passenger EV/Screen EV/Subscriber P/B, EV/NAV, EV/IC EV/BOE2 & EV/EBITDAX3
multiple defies the principle of consistency it is popular for sectors where breakevens are distant 2BOE = Barrel of Equivalent (One Barrel = 159litres) 3EBITDAX, where X = Exploration expenses
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Recommended Reading Books 1. Mckinsey Valuation 4th Edition Tim Koller, Marc Goedhart & David Wessels 2. Investment banking Joshua Pearl & Joshua Rosenbaum 3. Stock Valuation: A guide to Wall Streets most popular models Scott Hoover
Recommended Articles 1. The right Roles of Multiple in valuation Mckinsey Quarterly 2. The Conundrums of Comparable Company Multiples Howard E. Johnson 3. The Trouble with Earnings & PE multiples Alfred Rappaport & Michael J. Mauboussin
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