Relative Valuation:

Using ratios of comparable firms to value your firm

João Carvalho das Neves

Professor of Business Administration
ISEG

© J.C.Neves, ISEG 2018 1

What is relative valuation?

 Relative Valuation – compares the price of an asset sold in the
market to the market value of similar assets.
 Relative valuation requires peer companies in the same industry,
preferably with similar:
 Businesses
 Technologies
 size
 geographies
 We use:
 Historical data - most actual data or trailing multiples
 Forecasted data - Forward multiples
 The approach
 Equity approach – share prices data
 Entity approach – enterprise value data

© J.C.Neves, ISEG 2018 2

1
 Advantages
 Very easy to use

© J.C.Neves, ISEG 2018 3

Disadvantages of this method

 Can be applied if there is quoted companies for

comparison or data from other transactions
 Peers may not serve as a proper comparable
 Peers may not be valued correctly
 Historical data and actual data may not be a good
indicator of value (future matters for valuation)
 Share prices have expectations incorporated, and
market may have different expectations for different
peers

© J.C.Neves, ISEG 2018 4

2
 The process of a relative valuation
1. Identify comparable companies with the SUBJET OF VALUATION
(company or business you want to value) – Similar businesses,
similar size, similar technology, similar geographies, etc.
2. Obtain market values for those comparable companies
3. Create multiples (ratios) using market values and financial data for
these comparable companies
4. Multiply these multiples of comparable firms to the financial data
of the SUBJECT OF VALUATION
5. Control for any differences that may exist between the
COMPARABLE FIRMS and the SUBJECT OF VALUATION, to judge
whether the value of the target is under or over valued

© J.C.Neves, ISEG 2018 5

The use of relative valuation

 SUBJECT OF VALUATION:
 Quoted firms
 Unquoted firms
 Group of companies
 Subsidiaries
 Strategic Business Units (SBU)
 One business
 SOURCE OF COMPARABLES:
 Quoted firms – daily market prices (between minority shareholders)
 Quoted firms – takeover bid (acquisition of majority)
 Transactions of unquoted firms
 Transactions of businesses

© J.C.Neves, ISEG 2018 6

3
 Relative valuation is commonly used
 Most of stock market investors use relative valuations.
 Almost all of equity research reports use, in some way, multiples
and comparables.
 Rules of thumb based on multiples are common and eventually are
often the basis for final judgments.
 Discounted cash flow valuations (Intrinsic value) are more and
more used by consulting and corporate finance firms, but they
often use relative valuations for testing the Intrinsic Value.
 When applying discounted cash flow valuation, it is necessary to
calculate the continuing value (or terminal value). There are two
approaches:
 Discounted cash flow approach or;
 Relative valuation approach

© J.C.Neves, ISEG 2018 7

Comparable should be comparable

 The sample of comparable

firms should be comparable to
the TARGET – size, industry,
businesses, technology, etc.;
 And use identical accounting
principles such as:
 Capitalization of expenses
 Depreciation & Amortization
 Provisions
 impairments
 Capital gains and losses

© J.C.Neves, ISEG 2018 8

4
 Why relative valuation is relevant
 Even if you are an apologist of discounted cash flow valuation (like
me), you must agree that presenting your findings on a relative
valuation basis, will make your audience more receptive to your
valuation.
 Relative valuation can also help to find some weak spots in
discounted cash flow valuations, to fix them.
 The problem with multiples is not their use, but their abuse.
 If you can find ways to frame multiples right, you should be able to
use them better.

© J.C.Neves, ISEG 2018 9

Most traditional EQUITY approach

multiples: This is a direct
estimation of
the equity
 PER - Price Earnings Ratio value
 PBV - Price Book Value
 PCE - Price to Cash Earnings
 PS - Price to Sales
 Price per unit of specific EQUITY
industry variable
 Production capacity;
ASSET
 Effective production
 (price per ton; price to
kWh, price per number of golf LIABILITIES
rounds, etc.)

© J.C.Neves, ISEG 2018 10

5
 Multiples based on Share Prices

= + &! " + # +$ "

$ % = 200( ! " ) "

© J.C.Neves, ISEG 2018 11

Descriptive tests for multiples

 What is the average and standard deviation for this multiple,
across the universe/sample?
 What is the median for this multiple?
 The median is often a more reliable comparison multiple.
 How large are the outliers to the distribution?
 How do you deal with the outliers? Throwing out outliers may seem
an obvious solution, however if all the outliers lie on one side of
the distribution (they usually are large positive numbers), this can
biased the estimate.
 Are there many cases where the multiple cannot be estimated?
Ignoring these cases may bias the estimate of the multiple?
 How has the multiple changed over time?

© J.C.Neves, ISEG 2018 12

6
 Analytical tests
 What are the fundamentals that drive the multiple?
 Every multiple has a embedded model with variables that drive
discounted cash flow valuation such as growth, risk, return, etc.
 Using a simple discounted cash flow model and basic algebra should
yield the fundamentals that drive a multiple
 How do changes in these drivers change the multiple?
 There is a specific relationship between a fundamental (like growth,
cost of capital) and a multiple (such as PER).

© J.C.Neves, ISEG 2018 13

Rationale of equity approach multiples

using the Gordon model for a stable-growth model

DPS P0 – Price per share

P0 =
ke − g DPS – Dividens per share
k – cost of equity
g – growth rate
P0 DPS 0 × (1 + g ) 1 Payout ratio × (1 + g ) Payout = Dividends/Net Profit
PER = = × =
EPS 0 EPS 0 k−g k−g
PER – Price earnings ratio
EPS – Earnings per share
P0 DPS 0 × (1 + g ) 1 ROE × Payout Ratio × (1 + g )
PBV = = × =
BVPS 0 BVPS 0 k−g k−g PBV – Price book value
BVPS – Book value per share
ROE – Return on equity
P0 DPS 0 × (1 + g ) 1 Pr ofit M arg in × Payout Ratio × (1 + g )
PS = = × =
SalesPS 0 SalesPS 0 k−g k−g PS – Price to sales
SalesPS – Sales per share
Profit margin = Net profit / Sales

© J.C.Neves, ISEG 2018 14

7
 Multiples based on Enterprise Value (EV)
approach
First you estimate EV then
 EV to EBITDA you deduct debt and
 EV to EBIT minority interests to obtain
the estimation of Equity
 EV to Sales
Value for shareholders
 EV to Book value of assets
 EV to Replacement value of
assets (Tobin’s Q)
 EV per unit of specific industry EQUITY
variable
 Production capacity;
ENTERPRISE
 Effective production
 (price per ton; price to kWh, DEBT AND
price per number of golf MINORITY
rounds, etc.) INTERESTS

© J.C.Neves, ISEG 2018 15

Enterprise value to EBITDA

Classic Version

Firm Value Market Value of Equity + Market Value of Debt

=
EBITDA Earnings before Interest , Taxes and Depreciation

The No-cash Version

Enterprise Value Market Val ue of Equi ty + Marke t Value of Debt - C ash

=
EBITDA Earnings before Int erest, Tax es and Depreciati on
Technical Note:
When cash and marketable securities are netted out of the enterprise value
then, income from the cash and securities shouldn´t be in the denominator

© J.C.Neves, ISEG 2018 16

8
 Reasons for market use of EBITDA
 The multiple can be computed even for firms that are reporting
net losses, as long as EBITDA is positive
 The multiple seems to be more appropriate than the
price/earnings ratio in most cases
 EBITDA is a better estimate of cash flows from operations that can
be used to support debt payment, at least in the short term.
 EBITDA is a good estimate of cash flow prior to CAPEX
 By looking at enterprise value and cash flows to the firm, allows
for comparison across firms with different financial leverage.

© J.C.Neves, ISEG 2018 17

Example: Information about an hotel

 Fixed assets per room =

55 000 €
 No. of rooms = 900
 Working capital requirements
= 2 300 k€
 Cash in hand = 300 k€
 Debt = 45 000 k€
 No. of shares = 1 000 000

© J.C.Neves, ISEG 2018 18

9
 European Hotel Firms Multiples: An example in
31/12/20xx

European Firms EV/Sales EV/EBITDA

Accor 1,7 9,6
De Vere 1,7 7,9
Hilton Group 1,1 9,5
Jarvis Hotels 1,9 6,9
Millenium & Copthrn 2,7 10,6
NH Hotels 2,7 9,7
Six Continents 1,7 6,9
Sol Meliá 3,0 12,7
Thistle Hotels 3,3 8,7
Whitebread 1,5 7,2
Average 2,13 8,97
Median 1,80 9,10
Standard Deviation 0,73 1,85

© J.C.Neves, ISEG 2018 19

Example: Valuing the hotel with EV to Sales

 The amount of sales of the hotel: 24 500 k€.

 Average of EV to Sales of 10 european companies in 31/12/20XX:
2,13

What is the
equity value?

© J.C.Neves, ISEG 2018 20

10
 Example: Valuing the hotel with EV to
EBITDA

 The average of the EBITDA margin is 24,5%.

 The target hotel has an EBITDA margin that is identical to the
industry.
 The average of the EV to EBITDA of 10 comparative hotels is 8,97

What is the
equity value?

© J.C.Neves, ISEG 2018 21

Advantages of Multiples based on Enterprise

Value Vs Equity Value

 Debt effect
 Tax effect
 Accounting policies avoided
such as – Amortizations &
Depreciations, Provisions and
Impairments

© J.C.Neves, ISEG 2018 22

11
 Pros and Cons

Pros Cons
 Easy to apply  Market is efficient
 Recent market deals
 Identical accounting principles
 Identical cost structure
 Similar product mix and
product pricing
 Similar market segment and
Customer behavior
 Etc.

© J.C.Neves, ISEG 2018 23

Syndicated Groups Assignment

 Syndicated Groups will use Champagne Leblanc-Lenoir Case to do a
relative valuation using comparable companies and data in the
case study

© J.C.Neves, ISEG 2018 24

12