Chapter 6 modelling innovation - teaser


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Chapter 6 focuses on describing the methodology on how to perform a comparable companies analysis, answering the following questions:

What is the Efficient Market Hypothesis?
How is a comparable companies analysis structured?
How to perform a practical comparable companies analysis.

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Chapter 6 modelling innovation - teaser

  1. 1. Modelling Innovation – CHAPTER 6 Chapter 6 - Comparable companies analysis Comparable companies analysis is the most frequently used valuation method in financial markets, particularly for quoted companies. Based on publicinformation, the share price is used to calculate the equity value and, adding net debt, the enterprise value of a basket of companies in the same sector iscalculated. These amounts are then compared with the companies’ revenues, EBITDA, EBIT or any other financial or operating metric to obtain a multiple. Theanalysis thus reflects market sentiment: the average multiples of a basket of similar companies, is attributed to the financial metrics of a target company to derivea valuation. If the markets were right, the intrinsic valuation using the DCF methodology and the relative valuation based on comparable companies analysiswould converge. If there is a difference between these two approaches, which is almost always the case, we can assume that either the DCF’s assumptions are notcorrect or that equity markets are overstating or understating the value of the company. In the context of an acquisition, it is relevant to note that comparable companies analysis does not reflect control premiums nor potential synergies andas a result, valuing a potential target using this method does not take into account the benefits and value implications of an acquisition. The relevance of thismethod is dependent on the extent the companies selected are really comparable to the company being analysed. From the mechanics point of view, certainadjustments are needed to make the multiples relevant. 6.1. What is the Efficient Market Hypothesis (EMH)? The Efficient Market Hypothesis (EMH) was developed in 1970 by Eugene Fama and dictates that at any point in time, market prices reflect allavailable information about a company’s value. In order to draw a different conclusion from the market, the analyst would therefore need to have access to insideinformation (which eliminates the EMH assumption of symmetry of information). EMH is a working hypothesis, which is needed to develop working theoreticalmodels. Several relevant economists and specialists have disagreed with this theory, Krugman noted that investors have mass behaviour1, focusing on certainactions and leaving aside others, which results in distorted share prices. Aside from the critics, how does this theory explain the performance of Warren Buffettand other successful investors who systematically manage to outperform the market’s benchmark returns? If this hypothesis were always valid, in an extremecase, the DCF method would not be needed. In practice, this theory falls through due to the imperfect and inefficient behaviour of supply and demand in the 1 Paul Krugman, "School for Scoundrels", New York Times Sunday Book Review, 9, August 2009 1
  2. 2. Modelling Innovation – CHAPTER 6capital markets. The practical consequence is that a credible valuation should take into account both the DCF and other relative valuation methods. The truevalue of a company can be estimated with greater accuracy by comparing the outcomes of different methods. 6.2. How is a Comparable Companies Analysis structured? Identify Adjust parameters Focus on relevant Conclusions of the Comparable to enable Multiples Analysis Companies comparison  Identify comparable companies The first step in applying the analysis is to identify a basket of comparable companies that will be analysed to extract relevant and reliable (comparable)multiples. Depending on the company being valued, different factors should be taken into account, as described below in Table 1. 2
  3. 3. Modelling Innovation – CHAPTER 6 Table 1 - Relevant factors in identifying comparable companies Sector Dimension Positioning Credit Factors Shareholders What are the Are the revenues of Level of Operational Capital Structure. Shareholder company’s main this company margins (EBITA). Credit Rating. structure. products? comparable to the Growth perspectives. Liquidity Issues. Liquidity. What are its main company analysed? customers? Is the market Where does this capitalisation company operate? comparable? The choice of comparable firms is subject to the process presented in the diagram below. After choosing the correct Region, the comparable firm shouldbe analysed according to Industry, Size and Activity or Product (Step 1). After the chosen comparable company is analysed, another Region is chosen and,subsequently, other comparable companies are chosen as well (Step 2). The amount of companies chosen is important: while the analysis should include as muchinformation as possible, using too many companies might create an inefficient analysis with companies that are different from the company that is beinganalysed. In practice, three or four companies per region is considered an appropriate level of detail. Diagram 1 – Identify comparable companies Step 1 Activity Region Industry Size Product Size Step 2 3
  4. 4. Modelling Innovation – CHAPTER 6  Focus on relevant multiples Step two consists in focusing the analysis on relevant multiples. Depending on the company that is being analysed and its sector of activity, the most relevantmultiples differ. The following table shows examples of relevant multiples by sector: Table 2 - Relevant multiples by sector Sector Multiples Energy, oil & gas Banks/financial intermediaries (BV = Book Value per share) Industry Most companies: Chemicals: Natural resources (mining etc.) Most companies: Gold: Media Cable and satellite: Cinema exhibition: Telecommunications Fixed and mobile: In the case of oil & gas companies for instance, the EV can be compared to the value of reserves (P1 being proven reserves, P2 probable reserves). Forbanks, the price per share can be compared to the book value per share to determine the relationship between the market’s valuation and the amount of capital inthe balance sheet. In the case of industrial companies, EV/EBITDA is the most widely used multiple. Some industrial companies are capital intensive and theEBITDA, which is a measure prior to D&A, is the right financial indicator that enables a meaningful comparison of companies with newer vs. older asset bases.The examples above are simply illustrations and sector knowledge is essential to perform a meaningful valuation using comparable companies. 4
  5. 5. Modelling Innovation – CHAPTER 6  Adjust parameters to enable comparison After choosing the comparable companies, some adjustments should be made to prepare an efficient comparison. Some companies may have differentfinancial year ends and therefore, the financial figures should be adjusted to enable a meaningful comparison. The adjustment is shown in the diagram below. 6.3. Calendar adjustments Diagram 2 – Calendar adjustments Some companies have different periods in which their financial statements are organized. Some financial years end in December and some endin June, therefore if the comparison is made between two companies with different financial year endings, an adjustment must be made. The diagram belowrepresents the issue in two different timelines: Year 0 Year 1 End in December End in December End in June End in June Valuation Period An example of calendar adjustments is given below with projected revenues: End of year Year 0 Year 0 Company A December 200 220 Company B June 150 160 Company B’s calendar adjustments are given by the following equation: 5
  6. 6. Modelling Innovation – CHAPTER 6 ( ) ( ) Other adjustments can also be made in order to make the chosen companies more comparable. The current share volume of a company, for example, isimportant to determine the Price-to-Earnings multiple. To determine the share volume the analyst should start with the authorized number of shares, and includeare non-issued shares that were attributed to management as part of option plans. The methodology for determining the right volume of shares is describedbelow. 6.4. Adjusting the number of shares Diagram 3 – Share Volume Adjustments Non-issued but authorised Authorized Issued Options Fully Diluted (convertible Share Volume bonds, etc.) 6.5. Multiples interpretation The range of multiples described above have their own interpretation when delivering information about the true value of the company. Profit multiplesare normally the Price-to-Earnings ratio and EV/EBITDA ratio, if these ratios are below the sector average then it could mean that the company is facing intense 6
  7. 7. Modelling Innovation – CHAPTER 6competition, or that there are few growth perspectives. The reverse is also true, the reasons that lead these multiples to be high are the same reasons that thesecompanies DCF is also high which are high growth perspectives and high return of invested capital. Revenue multiples are normally used for start-ups or forcompanies that have negative operational revenues. The EV/EBITDA ratio is frequently used as it enables a broader valuation of the company, independent fromits capital structure. This, however, allows the company to increase its debt levels without the effect being captured by the multiple. The interpretations of theposition of the company’s multiples, relative to the sector average are shown below. If the company’s multiples are above the sector’s average: • Market factors o Corporate governance o Company risk • Operational Factors o Advantage relative to competition o Closed domestic market o Operational efficiency o Better growth prospects o Lower cost of capital If the company’s multiples are below the sector’s average: • Market and financial structure factors o Lack of liquidity o Excessive use of debt • Operational Factors o Disadvantage toward competitors 7
  8. 8. Modelling Innovation – CHAPTER 6 o Lack of credibility of the management team The figures alone are not enough to substantiate a company’s valuation based on this analysis. The analyst should confront the multiples with thecompany’s operational and financial reality.The teaser is over! Thank you for downloading this preview. The book is work in progress and the full chapter will beavailable soon. Check for details on the books publication date. 8