Comparable approach Comparable companies analysis has application in M&A advisory, fairness opinions, restructuring, IPOs and follow-on

offerings, and share repurchases. Consider an IPO of a private company that does not have a public market valuation. To determine how public markets might value the company, an investment banker will establish the comparables universe, which may consist or one or more peer groups. He or she will use the operating metrics and valuation multiples of the public comparables to determine an appropriate valuation multiple for the private company. Example 4.X Practical Application Suppose you are an investment banker positioning a technology-focused third-party logistics company (your client) for an IPO. The company has no direct comparables, but can be legitimately positioned as either a pure-play logistics firm or a business process outsourcing (BPO) company. You expect your client to trade on an EV/EBITDA multiple. Comparable pureplay logistics companies currently trade at 8.1x LTM EBITDA, on average. Comparable BPO firms currently trade at 9.6x, on average. You would probably want to position your client as a BPO firm to take advantage of higher EBITDA multiples in that peer group and boost your client's valuation. 9.6x LTM EBITDA would therefore be your starting point is determining an appropriate multiple, and you might adjust the multiple upward if your client has better growth characteristics than comparable BPO firms, or downward if your client's business model is especially risky, for example. The valuation determined through comparable companies analysis does not reflect: The control premium a buyer typically pays in an M&A transaction, or The discount the public markets may apply to newly issued shares from an IPO.

Selecting the Peer Group

To select the comparables universe, you must understand the target company's business. Comparable companies will usually share the similar industry, business, and financial characteristics with the target. The following sources can be used to help identify suitable comparable companies: The target's annual report, 10-K (especially the section on competition), prospectus, and web site Proxy statements in which the target compares its stock price performance with a that of peers Analyst research reports S&P tearsheet, Value Line, and Moody's company reports Bloomberg

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You will be able to make the most meaningful comparisons among valuation multiples of companies in the comparables universe when peers have similar prospects for growth and return on invested capital (ROIC).

Data Collection
Once you have identified the comparables universe, the next step is to collect the necessary information on each comparable company to perform the analysis. You will need the following information for each company, as a minimum: The most recent 10-K, 10-Q, and/or 8-K earnings release (or Form 6-F and/or 20-F, in the case of some foreign companies) Consensus financial projections or a recent analyst research report with financial projections when consensus figures are unavailable News of any material events since the last reporting period for which you must make pro forma adjustments Next, plug the information you have collected into your comparable companies analysis spreadsheet.

Pro Forma Adjustments

Making pro forma adjustments to comparable companies' balance sheet items is often the trickiest part of comparable companies analysis. For example, if one of the companies you are analyzing announced a acquisition since its last earnings release, and the company intends to pay for the acquisition with cash, stock, and the assumption of debt, you must adjust the numbers in your spreadsheet accordingly. Specifically, you would increase the debt balance and basic shares outstanding, and lower the cash balance. Material events for which you should make pro forma adjustments include, but are not limited to: Acquisitions and divestitures/disposals Stock repurchases Debt financings Legal settlements

Projected income statement items such as revenue, EBITDA, and net income usually exclude non-recurring items and are pro forma for corporate events like planned divestitures, so you won't likely have to adjust these figures.

Analyzing the Results

To compare comparable companies effectively, you must understand why their multiples are different. Reasons why one company's projected EV/EBITDA multiple might be lower than that of a peer could include slower projected growth, declining margins, or higher risk, for example. Although metrics such as growth, margins, and risk are not explicit inputs to the EV/EBITDA calculation, they are implicit in equity value, which is a determinant of EV. It is often useful to compare one company's multiples to those of the peer group, collectively. To do so, calculate the high, low, mean, and median summary statistics for the group as shown in Exhibit 4.X. The median is generally the most meaningful metric, because it naturally screens outliers. Example 4.X Comparable Company Analysis Based on the following comparable company analysis, why might company Charlie trade at a premium to its peers?
Operating Metrics Valuation Metrics

Company

08E EBITDA Margin

09E EBITDA Margin

08E / 09E Rev. Growth

08E EV/ EBITDA

09E EV/ EBITDA

Alpha

22.3%

22.6%

9.6%

8.8x

8.4x

Bravo

18.4%

18.4%

8.7%

7.8x

7.5x

Charlie

25.2%

25.5%

12.7%

9.5x

9.0x

Delta

14.0%

13.7%

5.1%

7.1x

7.3x

High

25.2%

25.5%

12.7%

9.5x

9.0x

Mean

20.0%

20.1%

9.0%

8.3x

8.1x

Median

20.4%

20.5%

9.2%

8.3x

8.0x

Low

14.0%

13.7%

5.1%

7.1x

7.3x

Charlie likely trades at a premium (9.5x 2008 EBITDA vs. peer group median of 8.3x) because it has higher projected growth and margin improvement.

Checking Your Work

Here are some things to watch out for when conducting your analysis : Multiple trends Multiples will generally go down over time since the denominator usually increases from one year to the next, unless business is declining. Note that in Exhibit 4.X, Delta's EV/EBITDA multiple increases from 2008 to 2009. This indicates that Delta's EBITDA is expected to decline from 2008 to 2009, which could explain why Delta trades at a discount to its peers. Revenue growth Revenues of healthy companies generally grow over time. When you see negative revenue growth, you should investigate the reason. Revenue growth vs. margins Healthy usually improve their margins over time. When you observe strong year-over-year revenue growth concurrent with margins that decline from one year to the next, you should check that your margins are calculated properly and that their computational inputs are correct. Of course, if the company is not doing well, your calculations may very well be correct. In Exhibit 4.X, Delta's margins are expected to decline from 2008 to 2009, although the company is showing weak, but positive, revenue growth. You might want to investigate why this is so. Outliers When the denominator is very small relative to the numerator, extremely large multiples can result. Such might be the case when calculating the P/E multiple of a nascent high-tech company with little earnings but high growth and lots of potential. When an output value is very large relative to the peer group, try to determine the reason, mark the multiple as "NM" (not material) in your spreadsheet, and exclude the outlier from the calculation of summary statistics. Pro forma adjustments Be sure that you have made any pro forma adjustments properly, and that you have included adjustments for all material events not captured in the most recent filing. Convertible securities Be sure to treat in-the-money convertible securities as equity, rather than debt.

Formatting the Output

Multiples with typically low values, such as EV/Sales and P/E/G are commonly expressed to two decimal places in the format 0.00x to provide greater resolution for comparison within a peer group. Other multiples may be expressed to one decimal place in the format 0.0x.

Discounted cash flow

Key Components of a DCF

Free cash flow (FCF) Cash generated by the assets of the business (tangible and intangible) available for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the business. Terminal value (TV) Value at the end of the FCF projection period (horizon period). Discount rate The rate used to discount projected FCFs and terminal value to their present values.

DCF Methodology
The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset. Exhibit 4.X Advantages and Disadvantages
Advantages Disadvantages

Theoretically, the DCF is arguably the most sound method of valuation. The DCF method is forwardlooking and depends more future expectations rather than historical results. The DCF method is more inwardlooking, relying on the fundamental expectations of the business or asset, and is influenced to a lesser extent by volatile external factors. The DCF analysis is focused on cash flow generation and is less affected by accounting practices and assumptions. The DCF method allows expected (and different) operating strategies to be factored into the valuation. The DCF analysis also allows different components of a business or synergies to be valued separately.

The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding FCF, TV, and discount rate. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs. It is also common to run the DCF analysis for different scenarios, such as a base case, an optimistic case, and a pessimistic case to gauge the sensitivity of the valuation to various operating assumptions. While the inputs come from a variety of sources, they must be viewed objectively in the aggregate before finalizing the DCF valuation. The TV often represents a large percentage of the total DCF valuation. Valuation, in such cases, is largely dependent on TV assumptions rather than operating assumptions for the business or the asset.

Steps in the DCF Analysis

The following steps are required to arrive at a DCF valuation: Project unlevered FCFs (UFCFs) Choose a discount rate Calculate the TV Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present value Calculate the equity value by subtracting net debt from EV Review the results

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