All public companies are different just like all private companies, if they were alike then all companies would have same multiple. Relying 100% on the paid databases creates a room for error. To begin with one of the common oversight that most analyst do is use the numbers provided by the database, before using a multiple or a number one must make adjustment(s) for non-recurring items for our comparable companies’ financials which is often not done by the database provider.
Another most common pitfall while using this approach is selecting industry sector, business model and size of the Comparable Company which must be analysed. Similarly IBM which is a diversified and very large conglomerate (providing financial services, hardware, software and outsourcing services) cannot be selected as a comparable for a company that is purely into software or hardware. Another example can be of a company that is selling travel tickets exclusively through online channel can be a perfect comparable for a company that is selling movie tickets, although both are catering to different sectors, their business model is same.
Multiple selections are another step to watch. Since the market prices of peer groups cannot be compared in absolute form, these are converted to a standardized value relative to a key statistic, hence creating the valuation multiples. However, the decision making comes while selecting the Equity multiple or EV multiple and its respective value driver. While equity multiples focus on the value of equity, EV multiples are built around valuing the firm or its operating assets. The focal points which need to be taken care of while selecting is enumerated below:-
• Capital Structure – While comparing companies with differing capital structures, one has to consider the financial leverage utilized by the subject companies. Companies having similarity in operational terms will have different equity values because of the debt they carried in their books. Therefore, firm value multiples make more sense opposed to equity multiples, when comparing companies with different debt ratios. For Example: EV and MVIC are “capital structure neutral” ratios.
• Value driver – One needs to look at the respective industry sector and consider various financial metrics that drives the performance. For example, Price to Book Value ratio would be useful where assets are the core driver of earnings and is most widely used for capital-intensive industries such as Financial Institutions. Similarly, EV/Revenue multiples are widely utilized for unprofitable companies and EV/ EBITDA multiples are suited to companies with low Capital Expenditure.
• Outliers – For effective examining of comparable, once must identify the reason for having different multiples. When a company’s projected revenue growth is slower as compared to its peers it would give us higher multiples. Hence, it makes sense to eliminate them from the analysis. For example, Facebook, Twitter or LinkedIn are trading at higher multiples are considered as outliers.
This is not the end but these are some critical ones. Revisit for further update.