The trading multiples (or comparable companies) method is part of the Market approach family of valuation methodologies, which compare the subject company to similar companies listed on regulated stock exchanges.
The comparable companies method involves observing the implied trading multiples of listed peer companies (e.g. EV/EBITDA, P/BV, etc.), which are then applied to the subject company's relevant metrics as at the valuation date or forecasted.
Let's look at how to perform an effective and meaningful trading multiples valuation.
When to use the comparable companies method
Never forget: 1 great comp is worth more than 10 so-so ones. Choose quality over quantity, always.
First things first: no two companies are perfectly comparable. This is the biggest limitation of the Market approach. It is simply not possible for two companies to be the exactly the same in terms of size, profitability, capital structure, product offering, life cycle phase, number of employees, geographical presence, strategy, management team, and historical and future growth, to name a few. With this in mind, in applying the Market approach, you will need to settle for "good enough".
Compared to an unlisted subject company, listed peers are generally characterized as being larger in size and more diversified in terms of product/service offering and geographical areas served. Furthermore, the shares of an unlisted subject company are illiquid, while the stock of listed peers is traded on a regulated stock market with a significantly higher frequency.
When valuing a listed subject company, the management will be able to provide you with detailed financial projections, which reflect the strategic direction and expected results of the business. Additionally, you will have the market capitalization as another important reference point.
For all these reasons, trading multiples are typically used as a cross-check methodology, to support and validate the valuation range resulting from the application of the primary valuation method, most commonly the DCF or another Income approach methodology.
Alternatively, advisors may assign weights to the valuation ranges obtained by applying different valuation methodologies to arrive at a concluded range for the subject company, e.g. 50% weight to the DCF, 25% to the trading multiples and 25% to the transaction multiples.
In any case, know that the comparable companies analysis will have to be performed in every single valuation project in which the cost of equity is estimated based on a market participants basis. The data related to the listed comparable companies, in fact, will be used to estimate the average beta and gearing ratio considered in the CAPM (click here to jump to our article on how to estimate the discount rate).
How to perform a comparable companies analysis
Summarized below are the best market practices on how to execute a comparable companies analysis:
It is fundamental to obtain inputs directly from your client regarding the specific business sector in which the subject company operates and who the key market players are. Ask your client to share with you any updated industry reports that they may have.
In addition to leveraging your client's expertise, running a simple Google search has proven to be the most effective way to go to identify listed peers. Search for publicly available industry reports, and look for the members of sector-specific associations or participants to industry conferences and seminars.
Once you have a preliminary list of competitors, carry out further research on the Bloomberg terminal (use the function "RV", but don't depend on it, as it doesn't always give out relevant results) or on whichever platform you have access to (e.g. S&P Capital IQ).
Your peer set should include listed comparable companies headquartered in the domestic market of the subject company. Your set may be extended to include regional peers, if there are insufficient listed domestic players. NB: if you are valuing a company headquartered in a developing country, you should avoid considering peers headquartered in developed countries (and viceversa), for comparability purposes.
Once you have completed your search based on industry and geography, assess the comparability of each target to your subject company, in terms of size (e.g. revenue, total assets), profitability (e.g. EBITDA margin, profit margin), growth (e.g. % yoy growth of revenue), product/service offering and geographical presence (e.g. % revenue contribution by country/region), to name a few. In addition to the quantitative data directly downloadable from the Bloomberg terminal or other platforms, the peers' corporate websites and annual reports provide additional information you may need to perform this analysis.
Exclude from your peer set those comparable companies with a low free float (e.g. less than 10% of total shares outstanding).
Exclude from your peer set those comparable companies with illiquid shares, or stocks traded at a low frequency (e.g. fewer than 12 data points per month).
In case you are considering a pre-existing peer set, remember to check whether all of the peers are still listed (they may have been acquired since the date of your previous project) and, if needed, update the ticker. It is also good practice to re-run your screening: you may find new peers that were previously unlisted or discarded.
If you wish to consider the average trading multiples for your valuation, make sure to eliminate all outliers from the calculation of the mean. The average without extremes typically falls close to the median trading multiple. Many teams prefer to use the median directly and, in so doing, eliminate the subjectivity entailed in selecting and removing outliers.
Lastly, adjust the selected trading multiple by applying one or more of the following premiums and discounts, as appropriate:
Discount for lack of marketability ("DLOM"), if you are valuing an unlisted subject company, to account for the fact that its shares are not traded on a regulated stock exchange and are, thus, illiquid.
Size discount, if you are valuing a subject company that is significantly smaller than its listed peers, in terms of e.g. revenues and total assets.
Growth premium, if you are valuing a subject company that has recorded significantly higher growth rates than its listed peers (e.g. % yoy growth in revenues and/or EBITDA).
Control premium, if you are valuing a controlling stake in the subject company. Share prices, in fact, are based on transactions between minority shareholders, thereby implying a discount for the embedded lack of control.
How to perform a trading multiples valuation
As a general rule:
Use Enterprise Value multiples (e.g. EV/Revenue, EV/EBITDA, EV/EBIT) to value non-financial institutions. The EV/EBITDA multiple is by far the most popular. The EV/Revenue multiple (considered when EBITDA is negative) is generally only accepted to value young companies and start ups.
Use Price multiples (e.g. P/BV, P/E) to value financial services firms, as applying these multiples results in the direct valuation of a subject company's equity.
Unlike precedent transactions, which are obviously based on deals concluded in the past, forward trading multiples are generally available. Many listed comparable companies, in fact, are covered by equity analysts who provide their estimates on future key metrics within the equity research reports that they publish periodically. If you have financial projections for the subject company, you can apply the forward trading multiples (adjusted for the required premiums and discounts) to the appropriate forecasted metric (e.g. apply the median LFY+2 EV/EBITDA multiple to the LFY+2 EBITDA to estimate the subject company's Enterprise Value).
Alongside the trading multiples analysis, advisors will typically perform the transaction multiples analysis, which is also part of the Market approach family of valuation methods and involves the screening of M&A deals recently concluded on the equity stakes of comparable companies.
As aforementioned, share prices are based on transactions between minority shareholders, implying a discount for the embedded lack of control. In order to value a controlling stake in the subject company using trading multiples, adjust your trading multiples by the average or median control premium resulting from your precedent transactions analysis (click here to jump to the article on how to perform a precedent transactions analysis).
We hope you found this article useful. Make sure to download our Excel model template for the trading multiples valuation:
For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!