The reason that professional investors care about whether a company is sensibly valued or not is because they want to avoid shares that underperform the market.

If most of the good news is already factored into a share, its price can fall precipitously depending on the extent of the over-valuation or at the very least, it can slumber for many months as the fundamentals catch up with an over-extended rating.

In this article we discuss comparable company analysis, which is probably the most common method used by market analysts.

UNDERSTANDING HOW IT WORKS

Think about it as using recent sales of houses in your street as a good guide to the value of your own home.

The advantage of using comparable analysis, sometimes called peer group analysis, is that it is easy to calculate and allows an apple-to-apples comparison.

The financial metrics used broadly fall into four categories; earnings based, book value based, revenues based and sector specific metrics.

By calculating a sector average for each metric, investors can quickly identify ‘cheap’ and ‘expensive’ companies.

Some of the sector-specific metrics can be a little unorthodox especially in fast growing embryonic industries that haven’t reached profitability.

For example, during the dot-com bubble in the late 1990s internet companies were valued based on the number of eyeballs or unique monthly website visitors they attracted.

After all, you couldn’t compare companies’ profitability back then because there wasn’t any to speak of and some didn’t even have revenues.

More recently, when Facebook bought messaging company WhatsApp for $19 billion, some investors questioned the seemingly high price given that WhatsApp is a free service.

But analysts pointed out that Facebook was paying roughly $42 for each of WhatsApp’s 450 million users, which was a bargain compared with Facebook’s own $141 per user valuation.

WHICH EARNINGS-BASED METRICS ARE BEST?

Other than the price to earnings ratio, which can have limitations even when comparing businesses in the same sector because it doesn’t encompass debt, the most popular earnings-based multiples are EV (enterprise value) to EBITDA (earnings before interest, tax, depreciation, and amortisation) and EV to EBIT (earnings before interest).

EBITDA is a proxy for the cash generated by a business and is calculated before interest and tax payments, which means it can be used to compare companies in the same sector which have different financial structures and tax domiciles.

Similarly, EBIT is a useful metric because it a pure operating measurement and ignores interest payments and taxes which may differ even for companies in the same industry.

Enterprise value is a measure of a firm’s total value including the net debt or net cash on the balance sheet.

Comparing multiples for companies in different sectors won’t tell you which ones are cheap or expensive. To illustrate why, let’s compare pharma company AstraZeneca (AZN) to supermarket chain Tesco (TSCO).

According to data provided by Sharepad, Astra trades on an EV to EBITDA multiple of 21 times which compares with 8.8 times for Tesco.

However, it is the size of a firm’s EBITDA margin and the growth which determine the appropriate EV to EBITDA ratio. In general, higher rated shares have higher margins and growth rates.

Astra achieves an EBITDA margin of 20% compared with Tesco’s 6.2%.

It makes more sense to compare Tesco to other retailers because they are have comparable profit margins and growth rates.

It’s worth pointing out here that just because Sainsbury’s (SBRY) looks cheap relative to the sector doesn’t mean that it is cheap in an absolute sense.

It might be the case that the sector is expensive relative to its own underlying fundamentals and this highlights one of the disadvantages of using comparable analysis.

As the table shows Sainsbury’s trades at a discount to both Morrisons (MRW) and Tesco on EV to EBITDA and EV to Sales.

One of the main advantages of comparing companies in this way is that it can throw up possible anomalies and online retailer Ocado (OCDO) seems to qualify.

Some analysts might quibble at including Ocado as a peer, arguing the company’s customer fulfilment centre technology means that it should be considered as a technology firm.

Ocado trades at roughly 24 times the sector average EV to EBITDA multiple (203/8.5) and 13 times the average EV to Sales multiple (6.5/0.50), suggesting that investors see a much brighter future for the company than its peers.

Using sales to compare companies in the same sector is useful because revenue is typically more stable than profits and it can be applied even when there are no profits.

We can also infer future growth from the EV to Sales ratio. For example, to bring Ocado’s ratio into line with peers, its revenues would need to rise by 13 times, everything else being equal.

In such a competitive and relatively low growth market like food retail, this implies that Ocado will take market share. We can estimate how much by multiplying its current 1.8% share by 13, implying a 23% share.

Whether that is sensible or not is anyone’s guess, but the analysis helps to frame and quantify what is expected from the fundamentals of the company.

Comparable analysis is a popular and relatively easy way to identify potentially cheap and expensive shares, making it a useful part of an investor’s toolkit.

That said, valuation tools are only one component of company analysis and should never be relied upon in isolation.

OTHER MEASURES OF VALUATION

There are several ways to approach valuation. For example, analysts covering the banking and insurance sectors tend to use price to book values to compare companies because they are more stable than earnings.

In addition, banks and insurers are heavily regulated and need to maintain minimum levels of capital which makes book value more relevant to financial stability.

We plan to cover more of the most popular methods of valuing stocks in future editions of Shares.

‹ Previous2021-07-15Next ›