One method to value a business (target) is the comparable company analysis (Compco) or multiple analysis. We at CENAK use this method as one data point for company valuations in addition to cash flow models and other valuation approaches. The Compco is typically not used as a stand alone valuation method. Due to its relatively easy mechanics it is often used as a starting point or "back-of-the-envelope" method to get a general idea of a valuation range. In this series we will describe this method over the next few days and weeks.
The quality of the results of a Compco depends highly on the quality of the input data. In fact, the majority of the preparation time goes into making sure that the data used is consistent and applicable. The data needed for a Compco is:
- Target company's historic and projected financials (2 years forward)
- Comparable companies' historic and projected financials (2 years) as well as stock price and capital structure
The first and most important step in preparing a Compco is to identify publicly traded companies whose business model is similar to the company to be valued. For example, if the target company is a producer of PCs, then companies such as Dell, Acer, Lenovo and HP could serve as comparable companies. However, it can already be seen that there are differences even in this universe of comparable companies. For example, Dell markets its products almost exclusively through its website while others market their products through other distribution channels as well such as retail stores. HP produces other, higher margin products in addition to PCs such as printers. Lenovo is traded on the Hong Kong stock exchange and Acer in Taiwan. It is in the discretion of the analyst to adjust the analysis for these differences by taking into account different accounting treatments and general valuation differences between countries (country adjustment). Further, certain companies may trade at a premium because they are considered "best in class", while others may trade at a discount to the average. Some companies may have to be taken off the list because their valuation is based mainly on other product lines. In our example, HP's data would only be of limited use because HP's core business is computer periphery such as printers. HP's multiples should reflect this and be a blend of multiples of the different business segments. IF HP were to spin off its PC business tomorrow, it would trade at a different (probably lower) multiple than the combined business today. All of these factors will ultimately have to be considered in analyzing the final results.
Some industries may not lend themselves to the Compco due to the lack of comparable companies. The more comparable companies can be identified the better, however as a bare minimum a basket of at least five companies should be evaluated. If there are less than five or no comparable companies available at all, a close look should be taken at the underlying business model. For example, if the target company is in the commodity business but there is no other public company in the exact same space, then it might be worth looking at other commodity businesses as a proxy for the target company, even though the underlying commodities between the target company and the comparable companies might be different.
Compcos are of limited use if the target company is a start-up with no income or even revenues. Compcos compare certain financial multiples of companies that are applied to revenues and certain earnings measures (more about that in part 2). If there are no revenues yet it does not make sense to apply any multiples. The same holds true for companies with negative earnings (losses). As an example, Internet start-ups in the late 1990s often went public without having ever produced positive margins. These companies were sometimes valued using revenue multiples only. In the biotechnology arena, companies went public without having ever sold anything, making the preparation of a Compco meaningless.
Compcos can be prepared for parts of target companies if data is available for the division to be valued. This is routinely done for companies that consider spinning off a division. Conversely, divisions of comparable companies cannot be used for the analysis even if broken down financial information is available, because the stock price relates to the entire entity and reflects a blended value over all of the the company's divisions.
Despite these few limitations the Compco can be a very valuable tool for business valuations. Most businesses and industries today can be valued using this methodology.
Once a basket of comparable companies has been identified, the next step is to collect financial data about these companies. In part 2 of our series we will describe in more detail where the data can be found and how it needs to be adjusted for a meaningful analysis.
If you have any questions regarding the multiple analysis please contact us at any time.
Nice post on comps. Doing a good comparable companies valuation is certainly an art form. Here's an interesting tutorial and comps model template that may be useful to those interested:
http://www.financeocean.org/finance_articles/article/13-valuation-comparable-companies-analysis
http://www.financeocean.org/finance_documents/document/4-comparable-companies-analysis-model
Posted by: James | May 23, 2011 at 11:06 AM