A comparable companies analysis (“trading comps”) is a relative valuation methodology that uses financial ratio and trading multiple benchmarks, derived from similar companies, to determine an accurate valuation range. Trading multiples utilize a measure of value in the numerator (such as enterprise value) and divide by a financial statistic (such as EBITDA). Common multiples are based on enterprise value (EV) and price-to-earnings (P/E). Enterprise value is independent of capital structure and non-operational factors. Simplified, it is calculated by adding debt and subtracting cash & cash equivalents from total market capitalization (equity value). P/E is a measure of a company’s stock price to its earnings per share.
For illustrative purposes, this analysis will examine Pfizer, an American pharmaceutical company. Sourced from Bloomberg, Pfizer has a current share price of $43.14 and a total market capitalization of $249.37 billion, as of 11/23/2018. A typical comparable companies analysis will adhere to the following steps, which will be explained in further detail.
· Step I: Determine Set of Comparable Companies
· Step II: Source Financial Information
· Step III: Calculate Ratios and Trading Multiples
· Step IV: Benchmark Comparables
· Step V: Valuation
Step I: Determine Set of Comparable Companies
Bankers must first develop a detailed understanding of the target company, its industry, and relevant competitors. Oftentimes, investment banks will have internal lists of comparables that expedite the selection process. When developing a comparable companies analysis without existing coverage, bankers first identify the target’s key business and financial characteristics in the context of its industry. Afterwards, they screen the industry for similar businesses, often using Bloomberg and equity research sources. This analysis selected seventeen large multinational firms as Pfizer’s initial comparables, a broad inclusion based on size and market presence.
Step II: Source Financial Information
Each selected company was public and filed with the SEC. The primary filings used for this analysis were the most recent 10-K (an annual report) and 10-Q (a quarterly report). For foreign companies, financial data was sourced from the annual 20-F and non-filed quarterly reports. Theses filings contain historical financial performance over the last three years and can be used to calculate performance over the last twelve months (LTM) of operations Equity research reports and consensus estimates are most commonly used for projecting future financial data.
Step III: Calculate Ratios and Trading Multiples
The sourced data is then entered into Excel ‘input’ pages, which are prepopulated with relevant ratio and trading multiple formulas. While this process is fairly straightforward, non-recurring items are one major area of subjectivity, as they can skew calculations and produce misleading multiples. A non-recurring item is usually a one-time charge or gain that is not a normal element of operations. A typical example is a restructuring cost or a gain from the sale of a non-core business. Companies may disclose and comment on a particular event in the notes section of filings, but in other instances, determining if a data point is truly non-recurring can be a subjective process.
In this analysis, businesses were impacted by the 2017 Tax Cuts and Job Act, which lowered the U.S. corporate tax rate from 35% to 21%. Several domestic companies repatriated profits to the United States, resulting in large one-time charges that had a material effect on net income. For example, Johnson & Johnson recorded a $13.0 billion provisional tax charge in the fourth quarter of 2017, disclosed in its most recent 10-K.
Step IV: Benchmark Comparables
After information has been inputted, Excel spreadsheets produce key trading multiples and ratios. Common statistics are then benchmarked against those of the target company, considering industry environment and other long-term factors affecting individual companies. This analysis condensed the final multiples and ratios used for benchmarking, based on enterprise value, EBITDA and its associated LTM margin, and growth rates. The condensed benchmarking analysis is shown below, with Johnson & Johnson, Merck, and Novartis deemed Pfizer’s closest comparables. The analysis further tiered the other fourteen companies, providing a more complete industry picture.
In a more thorough analysis, a banker may consider other factors more specific to the particular industry being examined. There is a certain amount of subjectivity when determining comparables, as some bankers may favor a particular metric as a better encapsulation of value than others. After the benchmarking process, the companies are further evaluated based on their specific trading multiples and ratios, like EV/EBITDA and P/E. The condensed tables used for this analysis are represented below, with the three first tier companies possessing similar multiples when compared to the broader data set. If the multiples were widely disparate, a banker may further refine the closest comparables or reevaluate previous assumptions.
Step V: Valuation
After determining closest comparables and their respective multiples, this data is used to derive an appropriate valuation range for the target. Commonly, valuation is implied through three methods — EV/EBITDA, P/E for share price, and P/E for enterprise value. The process starts with a financial metric that is multiplied by an associated trading multiple to produce a defensible range of enterprise and share price values. This calculation also accounts for factors like net debt and fully diluted shares outstanding. Using this process, Pfizer’s valuation through each core method is shown below.
For this analysis, both Pfizer’s possible EV/EBITDA implied enterprise value and share price ranges are slightly lower than those of the P/E method. Pfizer’s current share price of $43.14 (as of 11/23/2018) fits in the upper bound of the EV/EBITDA range and in the lower-mid bound of the P/E range. Its current market cap of $249.37 billion fits in both LTM implied equity ranges, further suggesting that Pfizer is relatively properly valued, in light of its comps, by the public markets.
However, a comparable companies analysis is just one valuation method used by investment banks. When coupled with other methodologies, such as a DCF or LBO analysis, a more concrete depiction of a company’s value can be derived. Comparables are market-based, which can provide a clear comparison of the company versus its competitors but can be skewed by irrational market sentiment. Additionally, the value of some businesses and industries is difficult to capture through a traditional comps analysis. Overall, comparables companies analyses have some drawbacks but are quick and effective at appraising a company and are a crucial staple of valuation.