Determining the fair value for a business or stock is one of the most important parts of investing. There are numerous quantitative and qualitative components to this question and approaches to arrive at a value. A DCF, sum-of-the-parts, and using publicly traded comparable (comps) are the some of the most common methodologies. A look inside these reveals that this is not a science and it’s important to supplement financial and average valuation data points with critical research on market position, the competitive environment and product profiles. These are the basic steps when using publicly traded peers:
- Identify the list of companies: There are different viewpoints here. Some experts target a broader range of comparable firms and others believe in targeting a small group of very similar peers. The more alike the better. Often times, this is dictated by the industry. For example, if you are looking for apparel retailers in the US, there is a large list of companies to choose from. However, if you are trying to value a specialty hanger manufacturer, the options are more limited. Using SIC codes and identifying competitors all help to build out the list of companies. The more similar the companies are on the list, the better. Ideally it would have 7-10 similar companies but could be as small as two firms.
- Determine a list of key metrics: These are generally things like market cap, beta, dividend yield, debt/equity, total debt-to-capitalization, revenue growth, earnings growth, operating margin, and return metrics like ROE, ROA and ROIC.
From here it may become clear that one company is an outlier. It may have an issue with debt levels or have lower return metrics or another issue. Using a geometric mean or trimmed mean can eliminate an outlier or just remove it from the list of comps if it just does not fit.
- Determine preferred valuation metrics: Every industry is different, determine if EV/Sales, EV/EBITDA, EV/EBIT or Forward P/E are the preferred methods. For some industries, that are high growth and still losing money, it will be a multiple of sales, for others it will not be as apparent. Find what looks right based on the data, which data valuation metrics are most consistent. Also, it is critical to use forward looking multiples based forecasts. That means next years or the next twelve months estimates, use consensus earnings or your own.
- Adjust average multiple to apply to your firm: This is the part that is less precise. Based on some of the data in step two, the company being valued may appear better or worse than the others. This would increase/decrease the multiple to apply versus the average. But further work is still necessary and a dive into the company’s competitive position, how their products are viewed, and management performance also impacts the premium or discounted multiple the company should receive. This is where a firm such as Research Optimus can help conduct market research to identify difference.
Investors need to determine if the company they are valuing deserves a premium or discount versus the peer group. The simple math of finding the mean or geometric mean of a forward P/E is not enough. A market research can help determine if a company is a real market leader and a price setter versus a price taker. Management teams and other public sources often miss this critical information necessary as part of your valuation.
– Research Optimus