Why Look at Comparable Companies for Valuation
In the investment banking interview, new candidates need to know that the comparable companies approach is one of the primary valuation methods. It is also the most commonly used for benchmarking companies and are included in almost every client presentation – even if only in the appendix to see where companies are trading at. These are commonly known as trading comps or market comps.
Comparable company multiples will show where the company trades at on a relative level. In order to do this, there needs to be a comparison of value versus some other metric. There will be comps for the whole firm (enterprise value) and equity market capitalization (equity value) – with the most well-known multiples being EV/EBITDA and Price/Earnings. However, debt comps are also widely used – from Debt/EBITDA to Debt/Capitalization. So before an aspiring investment banker can figure out comps, they need to have a good handle on Enterprise Value and valuation.
Other well known trading multiples include:
- EV/[relevant unit for the industry]
- Retained Cash Flow/Debt
- Dividend Payout Coverage (as function of distributable cash flow)
As shown above, most comps tend to be on an enterprise value business as firms should be valued as a business as opposed to how it is capitalized. This generally assumes (which may not be true) that firms operate at their optimal capital structure.
Indeed, most companies with healthy balance sheets will tend to trade with an agnostic view to how much cash or debt they have – however, companies that are experiencing financial distress (especially where bonds trade well below face value) may trade at a discount to peers in terms of an adjusted EV owing to the uncertainty mired around the equity and the heightened volatility.
Senior investment bankers will try to explain why certain peers trade at a premium or discount on EV/EBITDA multiples and use this as a basis for any recommendations. Investment bankers will also look at the comps to identify possible idea generation – especially for companies that are less richly valued.
Investment banking junior staff will grab the equity market capitalization of the company and add other components in the capital stack to value each company from a current, observable market standpoint.
Spreading Comps in the Analyst Pit
Of course, to spread comps manually for every pitch book is not a good use of time. Most investment banking coverage or industry groups will have a comp database that covers all of their client universe. When investment bankers need to throw the comps in a new presentation, they can just grab the latest comps from the main file.
This obviously means that comps need to be up to date and thoroughly vetted. The general rule is that analysts will spread the comps and associates will check the comps.
At least in theory, comps should be updated the same day any new information comes out. So if a press release comes out in the morning (8-K) or if earnings are released in the evening, the analyst should adjust the comp to reflect the latest information as an efficient stock market will react to that information.
When analysts first start “comping” or “spreading comps”, it can be an intimidating exercise – even after going to the 6 week training and orientation that all major investment banks offer. The Excel comp sheet is huge and the first time comping a company can take quite a large amount of time, especially if it is a niche industry.
However, once analysts get into the swing of things, comps become a fairly quick exercise (30 minutes max) assuming that the company is not comped from scratch as it is easy to trace what was done before – assuming it was right – and companies do not usually change drastically from one report to the next in terms of capital structure.
New hires that do not have comp responsibilities (in particular, MBA associates who may be responsible for checking comps for accuracy) may find it helpful to comp from scratch in a copy of the comp file saved in their own personal drive. If the numbers line up, they can know it was done correctly.
This is particularly important for new associates who were not promoted from analyst, or analysts that have other experience coming in as a 2nd or 3rd year – they need to know the comps better than any first year or summer student. Any investment banker who cannot do the work cannot check the work.
Vetting Comps in Investment Banking
The reason why experienced hires are so useful in investment banking is because they have seen the same companies a thousand times and understand it a lot better than someone straight out of school, no matter how many A+’s they received in corporate finance courses.
So to a new analyst, it may not be obvious that the market cap being pulled is actually that of another peer. An industry expert that has been doing it for a few years will see this number and have it jump out at them.
This is why work is checked, checked and checked again in investment banking.
However, as a new hire – a great way to make sure that comps are right and to avoid getting a dressing down is to make sure that the new comp outputs line up fairly closely with the old comp outputs. If they do not line up, dig into the reason behind the change – often there is an error. If there is no error, the delta needs to be explained in a satisfactory manner.
Another tip is to read all of the financials and MD&A in detail – and this includes every note in the financial statements. Only then can an analyst gain context in terms of whether or not the items on the balance sheet make sense.