Having a solid understanding of Comparable Company Analysis ("Comps") as well as Precedent Transaction Analysis is crucial to succeed in any investment banking interview. Unlike the broader financial questions, Comp Analysis drills deep into your understanding of market dynamics, peer valuation, and financial benchmarks—vital tools in an investment banker's arsenal.
Building on the knowledge from our previous article on corporate finance interview questions, it's time to delve into the realm of Comparable Company Analysis. If you're yet to explore the corporate finance questions, we highly recommend you start there by clicking this link.
In this piece, we’re going to cover some of the intricacies of Comp Analysis, commonly encountered in investment banking interviews. We’ll help you grasp the nuances of assessing a company’s value in relation to its peers, a skill indispensable in the world of investment banking.
Are you ready to stand out in your next investment banking interview?
What is the concept behind multiple-based valuation?
The key idea of multiples is that of arbitrage. If you have two identical companies and one trades for 12x EBITDA and the other trades for 15x EBITDA, then you would always prefer to buy the 12x EBTIDA company as an investor because you get the same company for less money. Also, this would mean that either the valuation of the 12x company would increase because more investors would be interested in it, or alternatively, the valuation of the 15x company would decrease because less investors would be interested in it, but the key point is that once the market is in an equilibrium, two identical companies must trade at the same multiple. In practise, no two companies are identical, but you can strive to find the best possible “peer” companies which are similar and then benchmark them against the target to then arrive at a multiple.
What are the most common multiples used?
By far the most common multiple for mature businesses is the EV/EBITDA multiple. Other common multiples include EV/revenue, EV/EBIT, and P/E.
What are the advantages and disadvantages of using multiples to value a company?
The concept behind multiples is very simple and intuitive; everyone easily understands it and multiples can easily be compared across companies and industries.
Under the assumption that a comparable peer group exists, multiples will correctly point to the current market valuation of the asset and are not dependent on further inputs (such as WACC, terminal growth rate, etc.). If, for example, all companies within a well-defined peer group trade between 12-14x, then this will reliably set the valuation range for the target company.
Multiples only work when you can identify a good peer set of comparable companies. However, this can be quite difficult in practice as no two companies are 100% comparable.
Multiples need to be properly adjusted (e.g. you might want to take out the effects of a non-recurring item from EBITDA so that EBITDA is reflective of the ordinary course of business) which is time-consuming and (perhaps) prone to errors if done by an inexperienced analyst.
The stock market can be irrational and driven by emotions (i.e. fear vs greed) and therefore multiples can be higher / lower depending on the stock market without any changes in the fundamentals of the stock.
Multiples condense everything into one number and the reality can be more complex than that.
Care must be taken to understand the industry of the company because not every multiple will work for every industry. For example, you would not use an EBITDA multiple for a bank.
When would you not use a multiple based valuation method?
Trying to use multiples to value a company does not make sense if you simply don’t have a relevant peer group. Also, if too many multiples (e.g. EV / EBIT(DA), P/E etc.) cannot be computed because the performance metrics are negative, then the multiple-based valuation approach also doesn’t make sense.
How do you determine whether to use enterprise value (“EV” or “TEV” for total enterprise value) or equity value as the valuation metric in a multiple?
The valuation metric you must use depends on what performance metric you are using. If the performance metric is a figure that is available to all capital holders (debt + equity), then you must use enterprise value as the valuation metric. If, however, the performance metric is a figure that is available only to equity holders, then you must use equity value as the valuation metric. When looking at the P&L, if you are using anything above the interest expense line, then use TEV, if it’s below the interest expense line, then use equity value.
Does it make sense to look at EV / Net income multiples?
No, it does not make sense to look at that multiple. EV is the total company value available to all capital holders whereas net income is only available to equity holders; you are therefore not comparing apples to apples.
When valuing a company using multiples are you more interested in the lagging or forward-looking multiples?
You would give more focus to the forward looking multiple because the previous fiscal year is over and what you care about (i.e. what you pay for) is the future of the business. If, for example, you have a lot of confidence that the EBITDA will be significantly higher next year, then you are willing to pay for that by applying the appropriate multiple on next year’s EBITDA. Vice versa, if you think the EBITDA will decline next year, then you will want to pay less for the business by applying the appropriate multiple on next year’s forecasted EBITDA.
How high is the required control premium on average?
A common control premium seen historically in the market is between 20-40%. Please note though that there have also been transactions with control premia in excess of 100% and the paid premium heavily depends upon the respective industry, market environment, and competitive dynamics in the transaction.
What are shortcomings of a precedent transaction valuation?
The key problem is a lack of comparable transactions that occurred during the last 1-3 years. Also, please note that even if you find comparable companies that were sold during the last 3 years, they might still not be comparable transactions because you also need to consider other factors such as:
How much of the company was bought? A majority or minority stake?
Was the asset sold in a competitive auction or via a narrower sale in which price wasn’t maximised because the founder of the company wanted to sell the business to someone who would continue his legacy
Was the asset sold to a strategic (who could realize synergies and thus pay a higher price) or to a financial sponsor (who was unable to realize synergies)?
Have public valuation levels or debt financing terms significantly changed since the acquisition (e.g. because of a change in the central bank’s interest rate policy)?
Furthermore, there could potentially be a lot more reasons that have made this particular M&A deal unique and therefore unsuitable to blindly use as a reference point
Lastly, not all the relevant information about precedent transactions is publicly available and there will definitely be less info available than if you were doing comparable company analysis (“comps”)
Which criteria would you consider when putting together a peer list for a company?
You should consider both industry / business criteria as well as financial criteria.
Industry / business criteria:
Similar business description / industry focus
Similar product / service portfolio
Similar positioning in the value chain
Similar geographical footprint
Similar company size in terms of TEV and revenues
Similar EBIT(DA) margin profile
Similar revenue and EBITDA growth profile
Note that it will oftentimes be difficult to find peer companies that satisfy all of those criteria so in practise you have to evaluate the relevance of the different criteria. In terms of valuation, the two criteria which are typically able to explain a lot of the differences in valuations between peers are (EBITDA) margins and expected (EBITDA) growth profile. For precedent transactions, you would also want to restrict yourself to transactions which ideally occurred in the last 1-5 years (and that is assuming that no major economic event such as a financial crisis or significant shift in interest rate policy occurred in that timeframe).
Does it make more sense to value a company with an EBIT or EBITDA multiple?
EBITDA multiples are more common in practise, and they are often a good basis for comparison. However, that does not mean that EBITDA multiples are always better than EBIT multiples and what makes more sense depends on the industry. For example, EBIT multiples are often used for more heavy industrial companies (e.g. steel, cement, industrial machinery, etc.) which have high and recurring levels of depreciation resulting from large annual capex spend. Therefore, EBIT is quite comparable among these companies and takes the capital intensity of the business into consideration (because capex cycles out through depreciation) which EBITDA does not. As a result, EBIT multiples might be the preferred multiple for heavy industrial companies as it is closer to the cash flow than EBITDA.
What are industry-specific multiples and where do they tend to be used?
Industry-specific multiples (e.g. based on number of subscribers or website visits) are an alternative to multiples based on financial metrics (e.g. EBITDA). Industry-specific multiples tend to be most commonly used in venture capital as a lot of start-ups have not achieved sizeable revenues or profitability, yet. However, even mature companies are sometimes valued on specific industry multiples that make sense for that respective industry.
Some examples of industry specific multiples are:
SaaS businesses like Salesforce: EV / Annual recurring revenue (“ARR”)
Media services like Netflix: EV / Subscribers
Websites like Instagram: EV / clicks, or EV / unique visitors
Hospital or care homes: EV / Beds
Retail stores like Louis Vuitton: EV / EBITDAR (i.e. earnings before interest, taxes, depreciation, amortization, and rent)
Asset managers like BlackRock: EV / Assets under Management (“AUM”)
The above is just a small selection of possible industry specific multiples. If you are applying to a certain industry team, make sure you understand what multiples are used in that sector.
From the above, you can also see that you cannot only build multiples on financial figures like annual recurring revenues, but you can also build multiples on the key operational figures such as number of beds in case of a care home provider.
Assume that you have a company that trades at an EV / Revenue multiple of 3x and an EV / EBITDA multiple of 10x. Can you calculate the EBITDA margin?
You can re-write the above multiple equations to:
EV = 3 * Revenue, and
EV = 10 * EBITDA. Therefore:
3 Revenue = 10 EBITDA. Which means:
EBITDA / Revenue = 3/10 = 30%
What is the PEG ratio?
The PEG ratio is simply the P/E ratio divided by the expected EPS growth rate and is often in the range of 0.5x to 3.0x. For example, a company with a P/E ratio of 20x and an expected EPS growth rate of 10% will have a PEG ratio of 2.0x. PEG ratios are therefore more flexible than other ratios in that they allow the expected level of growth to vary across companies, making it easier to compare between companies in different stages of their life cycles. As EPS growth rates tend to be quite volatile year to year, it makes sense to use a more long-term EPS growth estimate.
Two companies in a peer set are very comparable, yet company A trades at a premium to company B, what are potential reasons?
There is an unlimited number of reasons as to why similar companies don’t need to trade at exactly the same multiple. For example, company A could be the market leader in the industry and have a better position due to superior products, better marketing, and / or by holding key patents. Also, the management team of company A could be judged as vastly superior to the management team of company B etc.
What happens to the P/E multiple of a public company on its ex-dividend date?
Let’s first look at the numerator, the share price. From the efficient markets hypothesis we know that the share price of a public company reduces exactly by the amount of the dividend. The reason for this is that the share price theoretically represents all the discounted future cash flows and paying out a dividend now reduces this amount. The denominator, earnings per share, is not affected by issuing a dividend and therefore paying out a dividend reduces the P/E ratio.
How would you use P/E multiples to estimate the share price in 1 or 2 years?
First, determine the company’s current LTM P/E multiple. Then use broker (or proprietary) estimates on its EPS in 1 or 2 years and apply the current LTM P/E multiple to those. This should yield the expected (or implied) share price in 1 or 2 years’ time.