Preliminary Valuation: Comparable Company Analysis
Absolutely.
If markets are mispriced, the acquiring firm is likely to get a bad deal. It will skew the whole analysis. Another disadvantage is that it ignores firm specifics. Also, the available past data might not be the best future estimate.
So as with anything, try to use this method in conjunction with logic and reason.
If an investment banker is working on an acquisition, the intrinsic value of the target firm is a pretty important piece of information.
There are three main methods of estimating this: premium paid analysis, comparable transaction analysis, and __comparable company analysis__. Here, the name really says it all.
No, that's not the case. A mean is a mean, so there's no reason to expect such a bias.
To summarize:
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No—while that's a true statement, it's not a disadvantage of the method. A takeover price has to be a little higher if it is to work.
What sort of thing do you think would make a company "comparable" so that its valuation could be used for this sort of estimation?
No, this may be tempting, but think about a large firm with nearly no debt and a small firm with 90% debt. They may have similar amounts of debt, but would be vastly different.
Right!
That's a good start. From there, you'll want to find companies of similar size (market capitalization), similar risk levels, etc. And try to get a lot of them. The more, the better here.
No, the name of the company isn't relevant at all.
Then you'll start looking at valuation metrics. These are ratios. You can value stock, using things like price to cash flow (P/CF), price to sales (P/S), and price to earnings (P/E); or you can use the enterprise value in the numerator rather than price. The enterprise value is the market value of debt and equity, minus whatever cash and investments the company has.
Just to be clear, how could enterprise value be manipulated if cash and investments weren't subtracted?
Yes!
It wouldn't make sense that the firm would be more valuable just because it visited the bank today. So the enterprise value is kind of like the capital gathered that is actually being put to work, not what's essentially sitting in a drawer somewhere.
No, that's not manipulation; that's business.
No, if cash wasn't subtracted anyway, this wouldn't matter.
Now, since enterprise value (EV) is both debt and equity, the denominator should be things that flow to both debt and equity; in other words, nothing that excludes interest expense. So EV/sales, EV/EBITDA, EV/EBIT, and EV/free cash flow are all fine ratios to use.
Once you have your valuation measures for all of the comparable companies, use some sort of average for each one. Mean and median are popular. This will likely lead to different estimates, so you'll have a variety of estimates. What do you think is better: a wide variety or a very tight range of values?
Yes!
No, a tight range would be much better.
The whole idea is to get an estimate of firm value, and so the less spread among your estimates, the better.
Comparable company analysis has some advantages. It ensures that the estimated firm value is comparable to other similar firms, and the data you need to run the calculation is easily available. That's nice.
But what sounds like a clear disadvantage from what's been described so far?
Similar name
Same industry
Same level of debt outstanding
A firm could borrow money and just hold it
A firm could borrow extra money for expansion
A firm could just hide cash and not report it on financial statements
A tight range
A wide variety
The estimated price will always be too low
The takeover premium will cause the price to be higher
If comparable companies are overpriced, the bid will be too high
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