WSP Red Book: Relative Valuation

What is the purpose of using multiples in valuation?

A multiple is a financial ratio that reflects the value of a company relative to a certain metric.

Multiples standardize value on a per-unit basis which helps for quick and simple comparisons between similar companies.

Context of the industry, peers, growth rates, and drivers must be understood for a multiple to lead to meaningful conclusions, though.

How do you determine what the appropriate numerator is for a multiple?

You determine the multiple based on who the financial metric in the denominator applies to. For example, EBITDA is available to all investors of a company because it sits above interest payments, preferred dividends, and principal repayments, so you pair it with EV.

On the other hand, NI to common is only available to common shareholders. So, you pair it with equity value, which is the value of the firm to common shareholders.

Walk me through the process of “spreading comps.”

1. Determine comps group

2. Collect relevant financials and data

3. Input financials

4. Calculate multiples

5. Apply multiples to target

When putting together a peer group for comps, what would some key considerations be?

You want to look across two categories: operational and financial.

Operational encompasses things like sector, products, customers, cyclicality, and geography.

Financial, then, applies to the size, margins, growth, credit profile, and return metrics of the companies.

Should the target company being valued be included in its peer group?

It depends. You could not consider it because that would skew the aggregated metrics towards the company’s current valuation, but at the same time the goal is to reflect what the market as a whole thinks because while it may be wrong on one stock, it should be accurate on the whole, and the target is apart of that whole.

What are the primary advantages of the trading comps approach?

Public Filings: Trading comps involves public companies, making data collection far more convenient since all their reports and filings are easily accessible online.

Less Data Required: Implementation is a key advantage of trading comps, as proper DCFs cannot be built without detailed financials and supplementary data. But to get a decent trading comps-based valuation, only a few data points (e.g., EBITDA, revenue, net income) are required, making it easier to value companies when access to data sets is limited.

Current Valuations: Trading comps reflect up-to-date, current valuations based on investor sentiment as of the present day, since it's based on the latest prices paid in the public markets.

What are the main disadvantages of performing trading comps?

• Less visibility into the implicit assumptions behind them

• Very hard to find true, reflective comps

• Market can be wrong, especially when it is a seldom traded company or there’s less visibility

To perform transaction comps, how would you compile the data?

Look at deal announcements, press releases, proxy filings, merger agreements, and SEC filings for historical context.

You can also use vendors like Bloomberg or CapIQ to pull research and look at projections.

What do transaction comps tell you that trading comps cannot?

Transaction comps tells you the control premium that an acquirer is willing to pay for a company that may be comparable to the target, while trading comps just tells you what the market is willing to pay for its shares.

Additionally, transaction comps can show that there is demand from acquirers for a business similar to the target and may show how they thought about increasing that value, which can validate a buyer.

In M&A, why is a control premium paid?

A control premium is paid because if people wanted to sell their shares with no additional upside, then they could just sell their shares. To incentivize them to agree to sell, the acquirer needs to offer them a premium.

Besides incentivizing existing shareholders to sell, what other factors lead to higher control premiums being paid?

Acquirers are willing to pay higher control premiums if they believe that they can realize revenue or expense synergies from the companies’ operations being meshed together.

Additionally, the more undervalued the acquirer might believe the company is, the more they’d being willing to pay a premium and still have a chance to keep the price they pay below fair value, this would also be common if the seller has been poorly managed and stymied or destroyed value that could be unlocked.

There could also be a competitive bidding process for the company, especially if the asset is scarce or a specific company needs exactly what is being offered.

Why is transaction comps analysis often more challenging than trading comps?

• Harder to find the data

• Harder to ensure the company is similar

  • Harder to make sure the market conditions are reflective and recent

• Also, you have to pay careful attention to the type of deal and circumstances of the deal to determine what could have driven any premiums that were paid.

When putting together a peer group for transaction comps, what questions would you ask?

What was the transaction rationale from both the buyer and seller's perspective?

Was the acquirer a strategic or a financial buyer?

How competitive was the sale process?

Was the transaction an auction process or negotiated sale?

What were the economic conditions at the time of the deal?

Was the transaction hostile or friendly?

What was the purchase consideration?

If the industry is cyclical (or seasonal), did the transaction close at a high or low point in the cycle?

When valuing a company using multiples, what are the trade-offs of using LTM vs. forward multiples?

• LTM:

  • Uses historical data when trying to make future projections, LTM is affected by non-recurring

  • Uses real data and not projections

• Forward

  • uses forward data which makes the projections more future-oriented, which is what you want

  • Use assumptions that can be inaccurate

Why might two companies with identical growth and cost of capital trade at different P/E multiples?

Earnings are not FCF.

**Growth and cost of capital are not the only drivers of value. Another critical component is the return on invested capital (ROIC). Besides having different ROICs, the two companies could very well just be in different industries or geographies. Other reasons may include relative mispricing or inconsistent EPS calculations, often caused by non-recurring items or different accounting policies.

Should two identical companies with different leverage ratios trade at different EV/EBITDA multiples?

In theory, Enterprise Value is neutral to capital structure changes, so no.

In practice, though, different levels of debt corresponds to a different WACC, which can raise value if it is decreased, or erode value if it is increased.

Should two identical companies with different leverage ratios trade at different P/E multiples?

Yes, because the equity value will incorporate the different leverages through its re-levered beta in Cost of Equity, and also different amounts of debt cause a different interest expense, which impacts NI.

Which multiples are the most popular in valuation?

The most popular multiples are EV/EBITDA, EV/EBIT, and P/E.

What are some common enterprise and equity value multiples?

EV/EBITDA, EBIT, and Sales

P/E, Levered FCF, Book

Why would it be incorrect to use enterprise value and net income in a multiple?

The comparison wouldn’t be apples to apples.

Enterprise value represents the interest of all investor groups, while net income is representative only of the interest of common shareholders.

So, pairing them is inconsistent.

Why might one company trade at a higher multiple than another?

There are a lot of reasons that two companies could trade at different multiples, but it all comes back to the value equation with cash flows, growth, and the discount rate.

Differences in these metrics lead to differences in multiples.

Intuitively, what does the P/E ratio mean?

Intuitively, it represents how much you have to pay for one dollar of earnings, because P/E is the same as share price/EPS. Because of this simplicity and uniformity, it is widely used for relative valuation.

A company is currently trading at 12.5x EBITDA, is it overvalued?

That is impossible to say with just that information. To determine if this company was overvalued, you’d need context surrounding its industry, operations, financial metrics, and comps. Value is always relative.

For example, if every comp had a similar growth rate and expectations as this target, but all had multiples around 5x, then you may be able to conclude that it is overvalued.

But, if the same is true but the comps trade at 25x, then you could easily conclude that this company is undervalued.

What does a high P/E ratio relative to a peer group imply?

• Higher growth rate

• Lower WACC

• Better cash flows (ROIC)

• Overvalued

• Low earnings for now or because of certain large investments that they believe will pay off (ties to growth rate)

A company has an EPS of $2.00 that has declined to $1.00 four years later. Assume its share price has remained the same at $10. Is its current P/E ratio higher or lower than its four year-back P/E ratio, and how would you interpret this situation?

The company’s P/E ratio is higher now because investors have to pay the same for a smaller amount of earnings.

We could interpret this in a few ways. One of them would be that the company is overvalued and that earnings have become too expensive. Another way is that investors expect earnings to increase in the future and are willing to pay a premium today.

Mechanically, the company could have issued more shares and diluted EPS or made a dilutive stock acquisition, but investors still view the company and those actions positively.

When would the use of the PEG ratio be appropriate?

The PEG ratio: (P/E)/g

Helps you standardize the P/E ratio amongst companies with different growth rates.

To interpret it, you assume that a PEG of 1 is fair value, above 1 is overvalued, and below 1 is undervalued.

Growth can be based on both trailing (historical) growth, or forward (projected) growth.

When would you value a business using the P/B ratio?

The P/B ratio can be used when the company's book value captures a substantial part of its real value. An example would be commercial banks, as most of their assets and liabilities are frequently re-valued and similar to their actual market values.

When should you value a company using a revenue multiple vs. EBITDA?

Revenue is more useful for earlier-stage or high growth companies that may be investing a lot so their margins and profitability is a poor marker of their true strength.

EBITDA is useful if you care more about cash flows and are looking at a more stable company that has a relatively stable margin structure.

How would you value a pre-revenue early stage internet company?

You could use alternative metrics like daily average users, subscriptions, stickiness, or TAM.

Why is calendarization a required step when performing comps analysis?

Calendarization is a required step because not all companies report on the same fiscal year timeline, so across companies financials will blend across different quarters. This can be especially impactful when valuing companies that are more cyclical, or drive the majority of their earnings in one or two quarters of the year.

If the market matters most when valuing public companies, do we even need a comps analysis? Why not just use the market cap directly to value the company?

Because the market can be wrong about a single company, but in theory it should have an aggregately correct view on peers as a collective. So, we compare how the market looks across them to see if it aligns with how they treat the target. If there’s a difference, you have to determine why and what expectations are causing that, and whether they are justified.

When applying a peer group derived EV/EBITDA multiple onto your target company, what is an argument for using the group’s median multiple instead of the mean?

Median is resistant to outliers. Meaning, it gets a better picture at what the middle actually looks like rather than being skewed by companies that trade at ridiculously high or low multiples.