Why Trading Comps Matter

Trading comps are one of the primary tools of the investment bankers – not just a throwaway investment banking interview question.

An industry specialist is supposed to know where things are trading and why, as well as what this value insinuates.

For junior bankers (analysts especially), a lot of time is spend just pushing work out the door given the heavy volume as opposed to truly understanding it. After enough iterations, analysts start to make connections and have a sense for when the numbers don’t feel right.

Associates are expected to know this and understand the reasons behind why a stock is trading differently from its peer set. However, the ones that can really connect the dots between the numbers and the underlying corporate finance theory and market expectations are the ones who make it up the ranks (or are able to generate alpha on the buy side).

Comps are market based and the fastest way to figure out a valuation range for a private company. Comps also are effective in telling someone analyzing stocks or a manager in a corporate making financial decisions the right story. However, the market (at least in North America) tends to be efficient and the comp should in theory line up with a more academic approach to how companies are valued – primarily in the form of a discounted cash flow. The enterprise value that is traded on the market should line up closely with a reasonable intrinsic valuation of the firm, otherwise something may be wrong and there may be an arbitrage opportunity.

The Right Way to Spread Investment Banking Peer Comparables

To really understand how companies trade, comps should be spread by hand in order to get a holistic view of the industry.

We do this by conducting peer benchmarking to tell a story about whether or not the multiples are lining up where they should be. For each industry, there will be financial and operational factors. 

An example would be fast service restaurants. We would want to look at all of the fast service restaurants that you can think of – Starbucks, Restaurant Brands International (Burger King, Popeyes, Tim Hortons), Yum! Brands (KFC, Pizza Hut, Taco Bell), McDonalds, Dunkin’ Donuts, Wendy’s etc. Then we want to have operational statistics for everyone – number of stores, square footage, foot traffic volume, average ticket size (average check), same stores sales growth. Everything. All of these things tell a story.

As you can imagine, spreading comps can be a very fast exercise or an extremely long and drawn out process, depending on what your managing director wants and how deep down the rabbit hole he wants to go.

Choosing the Correct Peer Comparables Set

From there, you will have to select the right comp set. Figuring out through a general Bloomberg or CapitalIQ screen is a useful exercise in terms of finding out for yourself, but it should be crosschecked against industry specialists who have refined the list (their screen started the same way) so you can understand the factors behind which ones should and should not make the cut.

Here are some sources for trading comps:

Investor presentations – Found on the investor relations pages of a company’s websites, they will usually have their own peer benchmarking here listing the companies that they consider to be their peer group. Beware, investor presentations are meant to showcase the company in a positive light as to how it is investible, so the peer set here may be favorable, omitting top performers and adding more dogs

Equity research – If you have access to EIKON or other research permissions, equity research generally picks a good set and offers peer benchmarking

Bloomberg screen – Data service providers such as Factset, Capital IQ and Bloomberg offer good industry screens, but they are usually crude and there are companies that make it in that should or should not

Fairness opinion (recent) – This is actually a document uploaded to regulatory websites so they must have extremely good reasons in choosing a comp set. The problem is that it can be dated.

10K competitors – like the investor presentations, the annual report of the company and the management discussion and analysis may offer a comp set. This has to, by law, be more objective than the investor presentation.

Industry Peer Benchmarking for Investment Banking

In spreading a comp, investment banking analysts have to be meticulous in terms of setting up a spreadsheet that is easy to follow, trace and audit. Cells with inputs should have detailed comments as to what page number and area of what document the number was taken from – and the corresponding document should be highlighted.

For quick thought exercises, analysts can use Bloomberg or CapIQ to spread a comp if it is outside the scope of their expertise. However, anything meant to be shown for a client should be done by hand. Each industry group should have their own best practices for how to spread a comp that have been refined over time. Capital IQ and Bloomberg numbers are likely to be inconsistent – they are populated by data monkeys who get paid way less in a third world country for cost savings.

Analysts who are responsible for a comp need to know how to answer quickly when challenged – they need to know what the number is and why they chose that number.

Absolute and relative figures are important in telling a story.

Analysts will want to get revenue, profit, cash flow, EBITDA and earnings for both historical and projected figures. We always want to look at one year and multiple years to see trends and current status – 3 years historical , LTM and 5 years of projections are pretty standard.

The historical figures should be comped by hand by combing through financial disclosures (10K, 10Q) while the projections for year 1 can be taken from management guidance. Management guidance usually does not go out by more than one year, so the rest of the years should be taken from equity research consensus medians.

For historical figures, analysts should remove unusual or infrequent numbers – which requires judgment. One time restructuring charges? Should be added back. If there are one time restructuring charges every year? Hard to say. If there are impairments, they should be added back – and sometimes this can be difficult because they may be hidden in the notes of the financial statements. 

How should discontinued operations be treated? What about equity investments? This should all come from the guidance of the more experienced in the investment banking group.

Ultimately, there should be the information needed to get profitability margins. What’s the EBITDA margin? What’s the operational margin? What’s the net income margin? This tells us which companies are better run and this can also tell us that maybe there are other divisions that make these companies not entirely comparable.

From there, an analyst should compare size, risk of operations, projected future growth, historical growth, profitability, liquidity, leverage and even ownership. A highly concentrated ownership structure with a significant shareholder can influence trading levels.