I’ve been spending a lot of time recently on refining my technical valuation skills for technical interviews that I have coming up.
During that time I have realized how important Trading Comparables (in banker speak Comparable Company Analysis) aka Trading Comps are not only as an investment banking valuation method but also as a useful investment decision tool.
All too often, it is quite common to hear some one say “Wow, this company has 20% EBITDA margins” or “Firm A only has a P/E of 15x which is cheap”.
These statements or single data points are irrelevant in the context of investment decisions unless they are compared against similar firms or “comparable companies”.
To put it explain it more plainly, lets use a fictitious example. Say someone points out that Firm A has net income of $100 Billion and trades at P/E of 10x and asks you if you would invest in it. Thats sounds pretty good, right?
But what if I were to tell you that a Firm B existed and has $200 Billion in net income, but only trades at a valuation of 10x earnings or a P/E of 8x.
Suddenly, that investment in Firm A doesn’t sound as good as the investment in Firm B. A lot of finance is about values in relation to other values.
By comparing these two different firms and their valuations we are doing a very basic, simple form of Comparable Companies or Trading Comps.
In investment banking, this form of analysis is one form of analysis that is used to value a firm that is either being bought or sold.
In trading/investing, it is used to see which company is “cheaper” or “profitable” relative to another.
Now to get to the more technical aspect of it…
I will present a more technical overview here of how to do a quick comparable company analysis utilizing some excerpts from
the Investment Banking Book: Valuation, Leveraged Buyouts, and Mergers & Acquisitions by Joshua Rosenbaum and Joshua Pearl.
I have asked and received permission from the authors to use this info.
From the book:
“Comparable companies analysis is (“comparable companies” or “trading comps”) is one of the primary methodologies used for valuing a given focus company, division, business, or collection of assets (“target”). It provides a market benchmark against which a banker can establish valuation…Comparable companies has a broad range of applications, most notably for various mergers & acquisitions (M&A) situationns, initial public offerings (IPOs), restructuring, and investment decisions.
The foundation for trading comps is built upon the premise that similar companies provide a highly relevant reference point for valuing a given target due to the fact that they share key business and financial characteristics, performance drivers, and risks. Therefore, the banker can establish valuation parameters for the target by determining its relative positioning among peer companies. The core of this analysis involves selecting a universe of comparable companies for the target (“comparables universe”). These peer companies are benchmarked against one another and the target based on various financial statistics and ratios. Trading multiples are then calculated for the universe, which serve as the basis for extrapolating a valuation range for the target. The valuation range is calculated by applying the selected multiples to the target’s relevant financial statistics.”
The book points out five steps…
I. Select the Universe of Comparable Companies
-This is finding companies that are similar to your potential investment, geographically, financial profile, same industry etc
II. Locate the Necessary Financial Information
-No further explanation needed here
III. Spread Key Statistics, Ratios, and Trading Multiples
-Putting all the statistics on a spreadsheet…important to put everything in LTM (Last 12 Month terms) and adjust each company’s financials for non-recurring items so that a true apples-to-apples comparison
IV. Benchmark the Comparable Companies
-Basically do an in-depth examination of the comparble companies to find your investment’s relative ranking and closest companies.
V. Determine Valuation
-Use the comps to determine appropriate valuation for your firm/use the other firms multiples to have a discussion about whether your target investment is undervalued/overvalued on a relative basis.
This is an oversimplification of comps…but basically in theory its as easy as it sounds…comparing similar companies to determine valuation for your potential investment.
For a more in depth analysis of this form of valuation and others used on wall street, I would highly recommend this book.
I have put a basic template for a company I analyzed right here, something like this is usually sufficient for investment purposes…BYD_Comps