Comparable Valuation

Table of Contents www.finaticsonline.com

Table of Contents

> Concept, Pros & Cons > Enterprise Multiples

> Process of Valuation > Benchmarking
> LTM & Calendarization > Fair Value Range
> Adjustments to Financials > Common Pitfalls
> Calculating Diluted Shares > Snapshots
> Concept of Enterprise Value > Interview Questions
> Equity Multiples > Recommended Reading
 Comparable Valuation
Introduction www.finaticsonline.com

Comparables / Relative Valuation / Trading Comparables / Comps / CompCo is a method of valuing companies under which
Value is derived based on a comparison of ‘Multiples’ within a set of peers under current market conditions.

Concept Pros Cons

The Classic Question: > Captures Market Sentiment > In the real world it is very
Is a low P/E better or a high one? > Works best in the short run difficult to find ‘comparable’
Most would say the former! However, that (between quarterly results) companies
may not always be correct. > Quick & easier to apply & explain > Myopic - Focus on quarterly
The answer lies in a Comparable Analysis
which helps figure out whether the higher
than fundamental approaches results rather than the long term
P/E stock is overvalued or valued highly as like DCF > Fair Value based on peer
a result of superior expected performance! > More relevant when comparison may imply that
Among other things, a Comparable Analysis inflow/outflow of funds changes exuberance will always result in
aims to determine fair value based on or is expected to change biased valuations irrespective of
current & expected fundamental performance,
Intangibles like quality of management,
significantly ‘Intrinsic value’
brand value, market share and track record > Very popular among Investment > Many Analysts use ‘Comps’ in
in terms of TRS – Total Return to Banks, Brokerage houses & the down cycle while using DCF
Shareholders. Stocks trading at a higher Mutual Funds. Implying that this in the upturn. Indicating that
multiple usually tick mark one or more of is one of the ways in which the Comps are likely to under value
the above conditions
majority decide fair value (for stocks when fundamentals are in
the short run) the up cycle and vice-versa
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 Comparable Valuation
The Process www.finaticsonline.com

The process of Comparable Valuation is fairly uncomplicated. It is a mix of both art & science. The Science lies in
calculations and determining which company should command a higher value while determining fair value is an art

Step 1 Step 2 Step 3 Step 4

Identifying the Comparable Spreading Comps Benchmarking Determining Fair Value
Universe Making calculations Companies with Similar Benchmarking would help
The Industry or Sector may > Margins & Ratios Sales, Market cap, Margins arrive at a range of
not be comparable as a > Last Twelve months and other Performance multiples. Average & Median
result of different products > Fully Diluted shares Metrics must be indentified Multiples of such companies
& markets implying different > Enterprise Value to determine ‘closest would help determine the
fundamental performance > 3yr CAGR sales & PAT comparable’ companies and fair value of the company in
and hence different Equity Multiples thus benchmark them question while Highest &
valuation. It is for this reason > P/E, PEG, P/B, P/FCFE against the company in Lowest Multiples will serve
that one must look at the Enterprise Multiples question to determine a range
Sub-Sector. > EV/Sales, EV/EBITDA,

E.g. Industry > Metals EV/EBIT, EV/FCFF

Sector >Alloys Sector Specific Multiples
Sub Sector > Non Ferrous > EV/EBITDAR, EV/Ton,

Alloys EV/Subscriber, EV/Plane,

EV/Employee, EV/branch…
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 Comparable Valuation
LTM & Calendarization www.finaticsonline.com

Calculating Last Twelve months (LTM) Calendarization

A.k.a. Trailing Twelve Months (TTM) sometimes also referred Company results are always reported as per Fiscal year (FY)
to as Latest Twelve Months. ended as decided by the management. In India, it is usually
LTM Data1 is simply calculated for the purpose of using the 31-Mar. A Calendar year – CY (Jan-Dec) is way of re-basing
latest available data as the Data from annual fiscal results companies that have different fiscal years. The process is
could be one or more quarter older. called Calendarization.
The calculation is very simple and involves extracting latest The issue starts with Financial Projections itself which are
available Annual results along with latest & corresponding made on FY basis so as to make it comparable to what the
previous year’s 9 months results company will report in future. The only way to make it
Annual Sales as on 31-Mar-09 >> Rs.1,200Crs comparable to other companies that have different Fiscal
Last 9 months ended 31-Dec-09 >> Rs.1,000Crs Years is to calendarize (restate in Jan-Dec terms) add
Previous 9 months ended 31-Dec-08 >> Rs.800Crs quarterly results and subtract corresponding quarters, like
LTM = 1200 + 1000 – 800 = Rs.1,400Crs LTM. However, in case of Annual Forecasts one may need
to proportionally alter it.
Note: 1This holds true for Income Statement items only.
Balance Sheet Data is cumulative and hence LTM will give E.g. If Company A has a FY of 31-Mar.
flawed results. Secondly, In India, B/S & C/F are not Sales for FY 2009 are Rs.1,200Crs while that of
made available quarterly! FY 2010E are Rs.1400Crs
CY2010E Sales = (3/12*1200) + (9/12*1500)
= Rs.1350Crs (Sales from Jan-Dec 2010)
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 Comparable Valuation
Making Adjustments www.finaticsonline.com

Why Make adjustments ? Items to be adjusted

Company reported formats are not consistent across Although one may have to make more adjustments than
companies and hence may create distortions when making the ones mentioned, below are a few general guidelines
comparisons. Secondly, items which cannot be forecasted
with ‘reasonable’ accuracy must be excluded. Such items are > Extraordinary Gains/Losses/write ups/write downs
‘non-operational’ and usually ‘non-recurring’ in nature. Such items are non-recurring in nature and typically
related to Foreign Exchange, one time write ups/downs,
When calculating multiples it is essential to capture losses due to strikes/lock-outs etc. Such losses must be
operational/sustainable performance only. This is because added back and a reverse treatment of such gains must
value cannot be consistently created through non-operational be made
means. Companies that have higher non-operational > Accounting anomalies1
gains/losses will have a greater risk resulting in a higher and Inventory adjustments – LIFO to FIFO
unstable beta. This will increase the Cost of Equity thereby Deferred taxes – The most popular ‘accounting
increasing the speed of the ‘treadmill’ and making Value shenanigan’ used by companies to ‘smoothen income’
Creation through ‘beating market expectations’ more difficult! Leases – A capital cost and hence should be excluded
from EBIT to reflect true Operational or Asset Efficiency
Note: These adjustments pertain to fundamentals alone. In Capitalizing vs Expensing – This can have a significant
the real world analysts often make adjustments to the
impact on earnings and hence distort related multiples.
multiples as well. Such arbitrary assumptions are
specific to every analyst resulting from their expertise
1Discussed in
& experience! Classroom 4
 Comparable Valuation
Calculating Diluted Shares www.finaticsonline.com

Fully Diluted Shares – The Concept Example

Many companies provide ESOPs to employees as a non-cash CMP INR 345
incentive. Such options when executed threaten to dilute
Earnings as ‘More no. of shares chase Earnings’. As an analyst you No. of Weighted ITM Proceeds
are required to calculate the maximum damage to existing Options Avg. Strike Options from Treasury
shareholders through such conversions. (in Lacs) Price (in lacs) Conversion Stock
The ‘Treasury Stock Method’ assumes that proceeds from all ‘In- 4,325 INR 238 4,325 1,029,350 2,984
The-Money’ (ITM) options shall be used to buyback shares – in a 6,236 INR 267 6,236 1,665,012 4,826
bid to minimize dilution! 8,793 INR 290 8,793 2,549,970 7,391
2,465 INR 356 0 0 0
Step 1 – Extract No. of Outstanding shares from Annual
8,576 INR 390 0 0 0
Report (or latest quarterly result)
Step 2 – Extract No. of Exercisable options in each Tranche No. of Shares 19,354 15,201
from latest Annual report
Step 3 – Calculate No. of options ‘In-The-Money’ i.e. O/S Shares 1,987,653
options which have an strike price lower than CMP Add ITM Options 19,354
Step 4 – Calculate No. of shares that can be bought back as
Less Treasury Stock 15,201
a result of the exercised options (i.e. Treasury Shares)
Step 5 – Add Exercised options & subtract Treasury stock to Fully Diluted Shares 1,991,806
derive Fully Diluted shares

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 Comparable Valuation
Enterprise Value www.finaticsonline.com

Enterprise Value – The Concept Visual Explanation

A.k.a. Total Enterprise Value (TEV) or Firm Value (FV)
Minority
Suppose you were to buy a Company which had Less
Interest
Debt worth Rs.1,000Crs, Cash of Rs.500Crs & Market Value of equity as Excess C&CE
Rs.4,500Crs. What would you pay for it? Other Non
The Answer >> Rs.5,000Crs (= 4,500 + 1,000 – 500) Equity Claims
How?? Say, you just paid for the Equity, what about the debt that you assume
(become liable to pay)? So it must be added. While cash can be used to pay
down debt and is hence subtracted! ST& LT
Enterprise Value represents the Value of the company (and not just the Debt
Equity!). It is a metric used to determine the value payable for buying the
entire firm.

Calculation = MV of Equity + Debt + Other Non Equity Claims – Excess

Cash & Cash Equivalents
Market Value Enterprise
or MV of Equity + Net Debt
of Equity Value
Where Net Debt = Debt + Other Non Equity Claims – Excess Cash & Cash
Equivalents

6
 Comparable Valuation
Equity Multiples www.finaticsonline.com

Equity Multiples – The Concept Common Equity Multiples

The guiding principle for calculating a multiple is that the > P/E or PER (Variant | CPE = P/CEPS)
Numerator and Denominator must be ‘consistent’ i.e. if the Calculated as CMP/Diluted EPS. It is a poor multiple as
Numerator represents Value paid by Equity the denominator EPS can be easily masked through ‘Income
must reflect a fundamental/financial item available to Equity. smoothing1’ measures while Sales, EBITDA & EBIT are
Equity Multiples measure value available to Equity Shareholders still tougher to manipulate! Secondly, P/E does not
alone. reflect the effect of leverage.
The Numerator of course, is Current Market Price or Market > M/B or P/B or (Variant P/ABV = P/Adjusted BV)
Capitalization. For the Denominator, starting from the top of the Calculate as Diluted Market Capitalization/Book
Income Statement the only item available to Equity is PAT value. Where Book Value = Share Capital + Reserves.
(and PBT if there are no preference dividends) P/B is more stable as compared to P/E and hence is a
preferred metric for the BFSI sector
Equity Multiples (more specifically the P/E multiple) are > PEG or PE/EG (Price to Earnings/Earnings Growth)
more popular on the street while bankers usually prefer
Calculated as PE/Expected Earnings Growth (3 year
Enterprise Multiples as they reflect performance of the
entire firm at an operating level. CAGR). As a substitute one may also use historical
earnings growth.
Other things being equal a Lower Multiple indicates a cheaper > P/FCFE
stock! Calculated as Diluted Market Capitalization/Free Cash
Flows to Equity . Price paid for sustainable cash flows.
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 Comparable Valuation
Enterprise Multiples www.finaticsonline.com

Enterprise Multiples – The Concept Common Enterprise Multiples

Enterprise Multiples measure value available to the whole > EV/Sales
Enterprise The metric is used for companies that have yet to
The Numerator is the Enterprise Value as calculated before break even or have faced an unexpected loss in
while the Denominator can only include Sales, Gross Profit, operational earnings
EBITDA and EBIT. If one went further down and included items > EV/EBITDA
like PBT or PAT it would go against the principle of consistency as The most commonly used multiple by bankers, the
discussed in the previous slide! metric captures operational efficiency of the firm
Items like Interest or preference dividend are not payable by the > EV/EBIT
entire firm but are cost of providing capital that are to be borne Although bankers say that EBIT creates noise in
by Equity Claimholders. forming a fair picture as depreciation may be
affected by accounting methods. We still believe that
Bottom-Line: Enterprise value is Capital Neutral i.e. It in Capital intensive sectors like Cement the metric
measures efficiency of the Assets deployed rather than a
makes more sense than EV/EBITDA as EV/EBIT
particular type of capital and so the denominator must also
be Capital Neutral! captures asset efficiency as well!
> Sector Specific Multiples
Other things being equal a Lower Multiple indicates a cheaper EV/Ton, EV/EBITDAR, EV/Subscriber, EV/Sqft.,
company! EV/Store, EV/Employee, EV/Plane, EV/branch etc.

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 Comparable Valuation
Benchmarking www.finaticsonline.com

Benchmarking What to look out for ?

Benchmarking is the process of comparing companies in the > Sales, EBITDA & PAT growth
peer set with the target company. It involves comparing Higher numbers indicate superior scaling up
financial & market performance along with other relevant capabilities, competitive advantages and
numbers. Benchmarking is part Art part Science. The Science lies management quality or leveraging parent company’s
in correct calculations while forming a ‘story’ about the contacts to secure orders
company’s current and expected performance is Art! A banker’s > Margins
job is to sell a company more than what it is worth and there lies Higher Margins indicate competitive advantage/s in
the art – The Story! terms of brand value, geographical advantage
> ROE, ROCE, Debt Ratio & ATO
The First step of course is to filter the data into Reflect profitability & Efficiency of the Firm & its
Tiers/Classes of similar Sales For e.g. Bracket 1
Equity. A higher ROE with a low ROCE indicates a
>Rs.10,000Crs , Bracket 2 Rs.5,000-10,000Crs, Bracket 3
Rs.1,000-5,000Crs etc. good use of leverage
The Second step involves a complete performance comparison > Promoter Holding
to extract companies that are similar to the Target A higher number indicates promoter confidence and
The Third Step involves excluding outliers on the basis of in turn leads to greater investor confidence resulting
performance or extreme Multiples
in a higher multiple. A very low number on the other
All performance measures must be calculated as LTM along with hand may have a higher multiple too as a result in
Last 3 year & forward 3 year Average speculation of a takeover!
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 Comparable Valuation
Determining Fair Value & Forward Multiples www.finaticsonline.com

Determining an Implied Fair Value Range Is the range over stretched ?

Calculating Implied Share Price (LTM or Forward) > The benchmarking process leaves only the most
Step 1 Calculate Average Multiple of closest comparables closely comparable companies. Now, the analyst
Step 2 Multiply the figure thus arrived at to the usually takes an average of multiples and uses it to
appropriate financial metric (for LTM or Forward basis)
E.g. Average EV/EBITDA of comparable companies is 4.5x this
determine the Fair Value of the Target. The process
will be multiplied by the Target’s LTM EBITDA of say of setting a range is usually taken as Low & High
Rs.1,500 to arrive at an implied LTM EV of Rs.6,000Crs multiples of the closest comparable group.
Suppose the Target has a Net Debt of Rs.3500Crs and 50Cr But what if one of the companies has a fairly higher
Diluted Shares it implies a per Share Value Rs.125 multiple than the others?
=((6,000-3,500)/50). The Same may also be done on a forward
> In such a case one may take an average of the group
basis using ‘Consensus Estimate’ where the above metrics
can be taken as an average of Analyst estimates. and add & subtract an arbitrary number to derive a
range of value. Or simple exclude the company that
Calculating Forward Multiples has a starkly different multiple!
To Calculate Forward Multiples one simply needs to divide
the CMP or EV by the appropriate Forward metric. For e.g. IF Min and Max of the closest comparable
E.g. Calculating Forward P/E group is 7.5x & 12.5x the Fair range for the
CMP Rs.500, Forward earnings in year1E >> 50, year2E >> 75 Target company is the same 7.5x-12.5x. However, if
(where ‘E’ indicates Estimated). The Forward P/E in Year1E the analyst perceives this to be very wide she may
& Year2E is 10x(=500/50) & 6.67x(=500/75) respectively. choose to calculate an average i.e. 10x
(=(7.5+12.5)/2). Now to derive a range he/she may
add & subtract 0.5x from it i.e. Range = 9.5x-
10.5x !
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 Comparable Valuation
Pitfalls in Application www.finaticsonline.com

Common Pitfalls in Application Why Enterprise Multiples are superior ?

One can very easily go wrong with Multiples because of their > Sales, EBITDA & EBIT are more stable
deceptively simple way of Calculation/Application. Although ‘Window Dressing’ is a common practice it
Below are a few commonly made errors. is more pronounced in EPS rather than items
available for the Enterprise!
> Treatment of Non Recurring Items > Capital Neutral & Reflect Operational Efficiency
One needs to make adjustments to EPS by adjusting for
EV multiples reflect operational performance and
non-recurring items as they do not reflect sustainable
income. As a rule of thumb any item that cannot be hence can be used to compare firms with different
forecasted with ‘reasonable’ accuracy must be adjusted Capital Structures.
for. Such adjustments will usually make the stock more > Reflect Selling price of the Firm
expensive i.e. will result in a higher multiple! Equity value can be very misleading for a banker as
> Incorrect EV calculation
M&As are not about buying stocks but about buying
EV represents the Value of the entire Enterprise and
hence one should include debt and non equity claims of companies. Equity Analysts primarily focus on the
all kind e.g. Preference shares, Convertible Debt/FCCBs, next Qtr EPS number. Whereas for bankers (Deal
& Deferred tax liability makers) and Credit Analysts quality of earnings &
> Incorrect Analysis long term sustainable profitability is more important!
A higher multiple may be a result of rumors (i.e.
> What if a company is loss making?
speculation) rather than fundamental performance. The
analyst must try to identify why particular stocks trade If a company is loss making all Equity multiples will
at substantial premiums or discounts through regular prove useless! That’s when one may use the EV/Sales
scanning of news pieces and research reports or EV/EBITDA multiple to judge fair value. 11
 Comparable Valuation
Snapshot - LTM & EV www.finaticsonline.com

LTM ended 8th-Apr-10 EV calculation

all figures in Rs. Crores all figures in Rs. Crores
Other Total Extra- Con-
Operating Operational Reported Other ordinary Adj.s Market Net Minority Pref vertible Enterprise
Company Name Sales Income Revenues EBITDA D&A EBIT PAT Income Items to PAT Adj. PAT Cap Debt STD LTD Interest Capital Debt C&CE Value

ACC 8,421 173 8,594 2,571 342 2,229 1,546 106 - 106 1,440 17,270 (166) 368 450 - - - 984 17,104
Grasim 19,653 - 19,653 5,895 962 4,933 2,809 255 - 255 2,554 23,161 4,146 864 3,395 - - - 113 27,307
Gujarat Ambuja 6,926 109 7,035 1,928 282 1,646 1,226 150 - 150 1,076 20,713 (229) 486 166 - - - 881 20,483
India Cements 3,694 34 3,728 963 225 738 410 3 - 3 407 4,025 2,177 274 1,988 - - - 85 6,202
Dalmia Cement 2,114 25 2,139 602 128 474 179 (26) - (26) 205 2,040 2,512 229 2,338 - - - 55 4,552
Ultratech Cement 7,001 66 7,066 2,169 379 1,790 1,174 58 - 58 1,116 13,726 2,760 723 2,142 - - - 104 16,486
Shree Cement 3,493 16 3,509 1,515 347 1,169 983 60 (45) 15 968 7,684 1,024 - 1,496 - - - 472 8,707
Madras Cement 2,865 11 2,876 1,305 182 1,123 398 8 - 8 390 2,966 2,915 490 2,463 - - - 39 5,881
JK Cements 1,742 - 1,742 481 68 412 242 3 - 3 239 1,342 540 101 564 - - - 125 1,881
JK Lakshmi Cements 1,414 - 1,414 335 73 262 228 12 - 12 216 919 411 35 703 - - - 327 1,330

Note: The data above is an illustration only!

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 15 Day Financial
Comparable Modeling & Equity Valuation
Valuation
Comparable
Snapshot - Valuation | Output Sheet
Output Sheet www.finaticsonline.com
www.finaticsonline.com

Promoter
3 yr CAGR LTM Margins LTM Enterprise Multiples LTM Equity Multiples
Stake

Capacity
52 week 52 week Diluted Shares (in Crore Adj.
Company CMP Sales PAT 31-Mar-09 EBITDA EBIT EV/Sales EV/EBITDA EV/EBIT EV/Ton P/E Adj. P/E PE/G
Low High (in crores) tons per PAT
annum)
ACC 920.05 365.00 903.60 18.771 2.263 8% -4% 46.21% 30% 26% 17% 2.0x 6.7x 7.7x $168 11.2x 12.0x -323.0x
Gra s i m 2,834.50 872.00 2,938.00 8.171 4.880 18% 24% 25.50% 30% 25% 13% 1.4x 4.6x 5.5x $124 8.2x 9.1x 37.7x
Guja ra t Ambuja 135.35 56.00 357.00 153.030 2.200 18% 3% 46.00% 27% 23% 15% 2.9x 10.6x 12.4x $207 16.9x 19.2x 617.3x
Indi a Cements 138.90 45.00 298.00 28.981 1.295 9% -3% 27.37% 26% 20% 11% 1.7x 6.4x 8.4x $106 9.8x 9.9x -294.4x
Da l mi a Cement 252.00 67.20 219.85 8.094 0.900 45% 18% 56.60% 28% 22% 10% 2.1x 7.6x 9.6x $112 11.4x 10.0x 54.8x
Ul tra tech Cement 1,104.05 678.00 1,346.00 12.432 2.190 25% 63% 54.78% 31% 25% 16% 2.3x 7.6x 9.2x $167 11.7x 12.3x 19.6x
Shree Cement 2,205.55 320.00 1,790.00 3.484 0.683 59% 216% 65.56% 43% 33% 28% 2.5x 5.7x 7.5x $284 7.8x 7.9x 3.7x
Ma dra s Cement 124.65 55.25 128.70 23.797 1.100 35% 66% 42.00% 45% 39% 14% 2.0x 4.5x 5.2x $119 7.5x 7.6x 11.5x
JK Cements 191.85 31.25 141.35 6.993 0.750 20% 63% 69.78% 28% 24% 14% 1.1x 3.9x 4.6x $56 5.5x 5.6x 8.9x
JK La ks hmi Cements 75.75 31.00 149.20 12.137 0.475 28% 48% 44.48% 24% 19% 15% 0.9x 4.0x 5.1x $62 4.0x 4.3x 8.9x

Medi a n - - - - - 22% 36% 46.11% 29% 24% 15% 2.0x 6.1x 7.6x $122 9.0x 9.5x 10.2x
Avera ge - - - - - 27% 49% 47.83% 31% 26% 15% 1.9x 6.2x 7.5x $141 9.4x 9.8x 14.5x
Ma x - - - - - 59% 216% 69.78% 45% 39% 28% 2.9x 10.6x 12.4x $284 16.9x 19.2x 617.3x
Mi n - - - - - 8% -4% 25.50% 24% 19% 10% 0.9x 3.9x 4.6x $56 4.0x 4.3x -323.0x

Note: The output sheet must also include ‘Forward multiples’ based on Consensus Estimates as discussed in Slide 9.

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 Comparable Valuation
Interview Questions www.finaticsonline.com

Is Comparable valuation In most cases DCF & Comps are complimentary i.e. one provides a sanity check to the other!
better than DCF ? However, in times of conflict it is better to rely on DCF. This is because Comps do not attempt to
arrive at Intrinsic value, implying that the market could easily ‘stretch’ valuations based on Comps.
This is because one cannot substantiate whether Infosys is correctly trading at an Earnings multiple
of 35x unless one can test it through at least one or more methods that Value a company based on
its Fundamentals. DCF ties Stock Value to fundamentals whereas Comps are driven by Sentiments
& Consensus Estimates! This also implies that when more money chases few stocks they are driven
primarily by demand-supply gap rather than fundamentals ! In such times the broader market relies
on Comps rather than DCF.

Which approach has more DCF Value is driven by Fundamental performance which does not change drastically between two
longetivity ? quarters. However, Multiples change every second indicating a very short life. Hence, Comps are
better suited between quarters while DCF should be relied upon for a longer horizon say >1 year

How does one forecast Typically Average of LTM multiples of closest comparable companies are multiplied by the
Share Price with Comps ? Consensus Estimate of the appropriate fundamental metric (the denominator).
E.g. Average of LTM adjusted P/E of closest comparable companies is 10x and Consensus estimate
of adjusted EPS for next year is Rs.12 implying a forward price of Rs.120 (=10 x 12)

How does one determine Although there are several formulas available to Forecast Multiples. The analyst typically divides
a forward multiple? Current Market Cap or Enterprise value by the appropriate consensus estimate.
E.g. Current Share Price is Rs.100 and Consensus EPS estimate is Rs.25, implying that Forward P/E
is 4x (=Rs.100/25). 14
 Comparable Valuation
Interview Questions …Contd www.finaticsonline.com

What are Consensus Consensus Estimates are Average (or Median) estimates for fundamentals or Multiples across the
Estimates ? entire universe of estimates for a given company. These are made available at Bloomberg,
Thomson-Reuters, Zacks, Yahoo Finance, Google Finance etc.

Why do we use Consensus Unlike DCF, the Comparable approach aims to capture market sentiment. Among other things
Estimates ? market sentiments are driven by Consensus Estimates and hence they primarily drive multiples.

Why not use FY data Fiscal Year (FY) data may be older by a quarter or more. Implying that it is stale and does not
instead of LTM ? influence current traded multiples/prices.

Calendar Year (CY) data is used to re-base companies with different FY endings. E.g. Companies
Why Calendarize ? with Mar, Sep, Dec ended results can only be compared if they have a common base i.e. Jan-Dec

Why are adjustments Non-Recurring items like Other Income, Extraordinary gains/losses and other one time items
cannot be forecasted with ‘reasonable’ accuracy and should be excluded since they distort Value.
made to fundamentals ?
Such gains should be subtracted and losses be added back to reflect sustainable income.

15
 Comparable Valuation
Interview Questions …Contd www.finaticsonline.com

Why and How are Diluted Diluted Shares are calculated to reflect maximum possible no. of shares coming into the market as
Shares Calculated ? a result of conversion of debt, warrants & ESOPs. Such dilution is a threat to existing shareholders
as their stake gets diluted and hence will reduce Share Price. The Treasury Stock Method (TSM) is
the most popular approach used. It assumes that proceeds from all In-The-Money (ITM) options are
used to buyback shares so as to minimize dilution

What factors/metrics are To start with, when possible one should look at the Sub-Sector and not Sector or Industry. Within
used to arrive at the that, one should look at companies with very similar products/product mix. Secondly, Sales should
closest comparable be given more weight than Market Cap else valuation will result in circular reasoning. Thereon, one
companies ? may use Geographic presence, Degree of Revenue Concentration, Capacity, Margins, ROCE & ROE,
Leverage ratios etc. to arrive at the tightest range of companies.

How does one determine Once the process of benchmarking has been carried out one may use the Min & Max of the tightest
a Fair Value range range to determine a Fair Value range

Can P/E or EV Multiples be A negative P/E indicates that EPS is negative (loss making company). EV can be negative when the
negative ? If Yes ,What cash component is relatively higher than Debt + Market Cap. Negative EVs usually occurs in times of
should be done ? Exuberance i.e. when markets crash and Market Value goes below fair value. A negative EV can be
seen in the BFSI sector as they are cash rich and during bearish phases they may trade well below
their fair value. In both the above situations one may use P/B as it is more stable. However, for
startups or companies that have accumulated losses even P/B will be negative!
16
In such extreme situations one is left with no choice but to use P/Sales!
 Comparable Valuation
Interview Questions …Contd www.finaticsonline.com

Can Share Price be Yes. One simply calculate EV and then subtract Net Debt to arrive at Equity value and finally divide it
calculated through EV by diluted shares to arrive at Value per share.
multiples E.g. Company A has an implied EV/EBITDA of 5.5x and estimated EBITDA of Rs.1000,
Current Net debt of Rs.2,500 and 300 diluted shares.
Its EV = 5.5 x 1,000 = 5,500 and Equity Value = 5,500-2,500 = Rs.3,000
while Value per share = Rs.3,000/300 = Rs.30

Consolidated Statements represent Sales, EBITDA , EBIT etc. contributed by Minorities as well. If
Why is Minority Interest one does not include Minority interest, the Value of the Enterprise will be understated and the firm
included in EV ? will appear cheaper than it actually is!

Excess Cash (not Operating Cash!) is subtracted as it may be used to pay down debt. In any case,
Why is Excess Cash the Cash available is a source and not an application of funds! Ideally, one must use all Cash
Subtracted from EV ? Equivalents while not including minimum required cash (i.e. Operating Cash)

While calculating a multiple the numerator must be consistent with the denominator. EV represents
Why not use EV/PAT or the value created by (or belonging to) the entire firm, hence, the denominator must be an item
P/EBITDA? available for all i.e. Sales, EBITDA, EBIT & FCFF. However, After EBIT all other items like Interest,
Preference dividends, Minority interest etc. are payments made to particular claimholders and are
hence not available for the entire firm. Therefore, EV/PAT or P/EBITDA are inconsistent.
One exception to the rule is P/Sales which is used in the Retail sector!
17
 Comparable Valuation
Interview Questions …Contd www.finaticsonline.com

The most popular multiples are P/E, P/B, EV/EBITDA, and P/CEPS [Cash EPS = (PAT + Dep.)/Diluted
What are the most Shares] in that order. In the service sector EV/EBITDAR is the norm. Where ‘R’ indicates rental/lease
popular Multiples ? expense and is a significant expenditure in the sector. It is added back as it is a charge payable to a
particular claimholder to fund assets and hence treated as debt. Irrespective of whether a company
leases/rents/buys assets its EV will remain same! (Remember: EV is Capital Neutral!)

Efficiency in each sector is driven by specific metrics. For e.g. in the Hotel industry EV/EBITDA will
Why are Sector Specific not reflect the additional EV created as a result of 500 rooms added. In such cases a sector specific
Multiples used ? multiple proves superior. EV/room – indicates how well has the company used each room to
increase Enterprise Value. Secondly, it acts as an indicator of premium/discount over liquidation
cost. E.g. if a room costs Rs.5Lacs to build and a company has 10,000 such rooms its liquidation
value is Rs.500Crs (although it is just a ball park number!)

Sector Recommended Multiple Sector Recommended Multiple

List of Sector Specific
Multiples Healthcare EV/Bed Airlines EV/Plane or EV/Passenger
Hospitality EV/Room Cement/Steel etc. EV/Ton
1
Retail EV/Sq.ft & P/Sales Multiplex EV/Screen
Telecom EV/Subscriber Print Media EV/Subscriber
IT & ITES EV/Employee Infrastructure P/B, EV/NAV, EV/IC
BFSI P/B Oil & Gas EV/BOE2 & EV/EBITDAX3
1Although the multiple defies the principle of consistency it is popular for sectors where breakevens are distant 18
2BOE = Barrel of Equivalent (One Barrel = 159litres) 3EBITDAX, where X = Exploration expenses
Comparable Valuation
Recommended Reading www.finaticsonline.com

Recommended Reading
Books
1. Mckinsey Valuation 4th Edition – Tim Koller, Marc Goedhart & David Wessels
2. Investment banking – Joshua Pearl & Joshua Rosenbaum
3. Stock Valuation: A guide to Wall Street’s most popular models – Scott Hoover

Recommended Articles
1. The right Roles of Multiple in valuation – Mckinsey Quarterly
2. The Conundrums of Comparable Company Multiples – Howard E. Johnson
3. The Trouble with Earnings & PE multiples – Alfred Rappaport & Michael J. Mauboussin
Comparable Valuation
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