hey guys welcome back to another video today we will be talking about the comparable companies analysis and this is a comprehensive video covering the start to finish analysis and how to really build up and select the companies that you're going to be comparing the your target company to and conducting the actual analysis using the necessary multiples so it is a very long but comprehensive video and I would recommend that you kind of watch it in parts and so this is also chapter one of the investment banking valuation leverage biots and mergers and Acquisitions second edition book by Joshua rosenball and Joshua Pearl this is an excellent textbook I've read majority of the textbooks that are out there with regards to Investment Banking and this is probably the most comprehensive and easy to understand kind of guide to learning the industry and learning the technical skills needed to build up a comparable company's analysis a precedent transactions analysis A discounted cash analysis building up you know leverage buyout decisions uh buy side and sell-side decisions as well so the textbook is incredibly valuable for anyone entering the industry or preparing for interviews so I've provided a link in the video description where you can go to Amazon and purchase the textbook if you are interested but in this video we're going to be talking about the comparable companies analysis and let's get started so the comparable companies analysis is one of the primary methodologies used for valuing a given Focus company it provides a market Benchmark against which a banker can establish valuation for a company and frequently used for various mergers and acquisition situations initial public offerings restructurings and investment decisions the foundation for trading comps is built upon the premise that similar companies provide a highly relevant reference point for valuing a given Target due to the fact that they share key business and financial characteristics performance drivers and risks therefore the banker can establish valuation parameters for the Target by determining its relative position among peer companies it focuses on reflecting the current value based on market conditions and in some cases it is more relevant than a discounted cash flow analysis and really the key to understand is that the comparable company analysis is another tool in the toolkit of an investment banker or analyst that is valuing a company you want to combine the comparables company's analysis with that of the precedent transactions analysis with the discounted cash flow analysis and any other type of valuation kind of procedure that you want to follow so it just is another point of view another perspective for which you can referred to so when you actually give your final valuation uh assumption and judgment you can stand by that and defend your your your projection okay so the comparable companies analysis is split into five steps you first select the universe of comparable companies you then locate the necessary financial information you then spread the key statistics ratios and trading multiples you then Benchmark the comparable companies and finally you determine the relevant valuation so a quick summary of those steps in Step One your the selection of a Universe of comparable companies for the Target is the foundation for performing trading comps while this exercise can be fairly simple and intuitive for companies in certain sectors it can prove challenging for others whose peers are not readily apparent in step two once the initial comparable universe is determined the banker locates the financial information necessary to analyze the selected comparable companies and calculate or spread the key financial statistics ratios and trading multiples in step three the banker is now prepared to spread key statistics ratios and trading multiples for the comparable Universe this involves calculating Market valuation measures such as Enterprise Value and Equity value as well as key income statement items such as eida and net income and so we'll actually go through each and this is probably the the the longest portion of the video we're going to be spending a lot of time on step three to really understand each of these metrics so that when you are in an interview or you are speaking to someone not only are you regurgitating information but you understand that information what you're speaking about okay in step four the next level of analysis requires an in-depth examination of the comparable companies in order to determine the targets relative ranking and closest comparables benchmarking serves to determine the relative strength of the comparable uh companies versus one another and the target the similarities and discrepancies in size growth rates margins and leverage for example among the comparables and the target are closely examined and so this is where really experience as a senior investment banker comes in not only are you kind of inputting the financial information which is relatively easy and any analyst can do that but you're also reading that information you're making and you're interpreting what it means which ones are more relevant and how does that impact the overall valuation in step five you're finally determining the valuation so the trading multiples of the comparable companies serve as the basis for deriving a valuation range for the Target the banker typically begins by using the means and medians for the relevant trading multiples such as Eva as the basis for extrapolating an initial range the high and low multiples for the comparable Universe provide further guidance in terms of a potential ceiling or floor so let's look at step one the selection of a universe of comparable companies for the Target is the foundation for performing trading comps to do so you have to study the target company thoroughly by considering both its business and financial profile and this is important a lot of the times when people kind of rush through this analysis the due diligence portion is always overlooked because they simply assume that okay because this compan is in the oil sector I can compare it to any other company in the oil sector no that's not the case you want to understand it's sub sector you want to understand its products and services its customers and end markets its distribution channels its geography there are so many things and so many differences within the business profile alone which could really eliminate some businesses which initially would be considered comparable companies right and that's the same thing for financial profile maybe the size profitability growth profile return on investment or credit profile might be different and therefore it would impact the Market's valuation of that company and therefore it would not be useful at the end of the day the comparable company's analysis is based 100% on the selection Universe you need to select the right businesses to compare the Target too if you're comparing them to the wrong businesses then you're going to get the wrong valuation and therefore you have failed to offer a strong service to your client or whatever you're trying to do okay at its base the methodology for determining comparable companies is relatively intuitive companies in the same sector or preferably sub sector with with similar size tend to serve as a good companies while this can be fairly a simple exercise for companies in certain sectors it may prove challenging for others whose peers are not readily apparent for a target with no clear publicly traded comparables the banker seeks companies outside the target score sector that share business and financial characteristics on some fundamental level the process of learning the in-depth story of the target should be exhaustive as this information is essential for making decisions regarding the selection of appropriate comparable companies towards this end the banker is encouraged to read and study as much company and sector specific material as possible the actual selection of comparable companies should only begin once this research is completed and so I've already emphasized this point it is important to conduct your due diligence on the Target first understand its business and financial profile and then begin to determine what the selection University and the comparable universe is okay so let's look at the business profile on each of the different considerations from a sector perspective it refers to the industry or markets in which a company operates a company sector can be further divided into sub sectors which facilitates the identification of the target's closest comparables the products and services are the company's products and services are the core of its business accordingly companies that produce similar products or provide similar Services typically serve as good comparables products are Commodities or value added Goods that a company creates produces or refines so in um nothing's on the top of my head but this is quite important you have to identify whether the product is a commodity or value added good if you are comparing it to a company or if you're comparing two companies where one uh it produces a commodity which you know they're price Takers versus price Setters then that analysis is unfair because at the end of the day the core the core of its business model is dependent on two different things you know in one case the the company is susceptible to the commodity price and it's supply and demand within the market whereas in the other they're setting their price because they're producing a value added good so it wouldn't be fair to compare a company that produces Commodities with one that produces value added goods and that's important to realize with regards to customers a company's customers refer to the purchasers of its products and services companies with a similar customer base tend to share similar opportunities and risks for example companies supplying automobile manufacturers abide by certain manufacturing distribution requirements and are subject to the automobile purchasing cycles and Trends so this is important you need to understand who are buying these products where is the demand coming from for their service or good where are the key drivers of Revenue growth are they in cyclical Industries or in stable Industries are they growing or declining right is there Cost Cuts or you know are they very are they spending lavishly right and also the end markets it's different from customers a customers a companies and markets refer to the broad underlying markets in which it sells its products and services for example a plastics manufacturer may sell into several end markets including Automotive construction consumer products medical devices and packaging end markets need to be distinguished from customers for example a company may sell into the housing End Market but to retailers or suppliers as opposed to home builders So within each end Market there are different customers and also different cyclic alties within for those customers so relative to Big Box retailers and you know stay-at-home moms and dads who might demand your products each have different buying capacities which you need to understand that's why the extensive analysis of not only the target company but the comparables company is very important okay distribution channels are the Avenues through which a company sells its products and services to the end user as such they are a key driver of operating strategy performance and ultimately value companies that sell primarily to the wholesale channel for example often significantly are different from organizational and cost structures from those selling directly to retailers or end users in addition geography companies that are based in and sell to different regions of the world often differ substantially in terms of fundamental business drivers and characteristics these may include growth rates macroeconomic environment competitive Dynamics paths to Market organizational cost structure and potential opportunities and risks so if you were to analyze a company that yes serves the same uh uses the same distribution channels serves the same customers at the in the same end markets but one serves the Canadian side and one serves the um the German side of the market well all of a sudden things change because they are on different economic paths even though from a Global Perspective yes you know when both of them are doing well you know they're both increasing but they're increasing at different rates of growth and different things impact the general macroeconomic environment of those markets so you need to understand those differences and you know if they're clear big differences in performance then it might not be smart to compare those two companies and rather find a company that also operates and and and serves the Canadian Market okay so from a financial profile uh size is typically measured in terms of Market valuation as well as key financial statistics companies of similar size in a given sector are more likely to have similar multiples than companies with significant size discrepancies in addition profitability a company's profitability measures its ability to convert sales into profit profitability ratios employ a measure of profit in the numerator such as gross profit eida ebit or net income and sales in the denominator so it's very important to understand the profitability of a company in addition there's a growth profile a company's growth profile as determined by its historical and estimated future financial performance is a critical driver valuation Equity investors reward High growth companies with higher trading multiples than slower growing peers in addition to return on investment Roi measures a company's ability to provide earnings to its capital providers and the company's credit profile refers to its credit and worthiness as a borrower it is typically measured by metrics relating to a company's overall debt level as well as its ability to make interest payments and reflects key company and sector specific benefits and risks the key comment I would make with regards to the business and financial profile is usually if if you spend a lot of time on the business profile and find companies that really share a lot of sim similarities with regards to the end markets the distribution channels and the customers that are buying their products usually the financial analysis will follow through and it will be quite similar as well as long as they they have the similar size usually their credit profiles are the same because they're dependent on the same customers whereas if you were to compare uh companies that don't follow the same business profile but follow the same Financial profile then the analysis is is different right and The credibility of your projection might decline but again this all comes down to experience within that industry and seeing multiple and doing multiple comparable companies analysis so that you can really make sure that you're confident in whatever you're standing by right so now you screen for the comparable companies once the target's basic business and financial characteristics are researched and understood the banker uses various resources to screen for potential comparable companies at the initial stage the focus is on identify companies with a similar business profile investment Banks generally have established lists of comparable companies by sector containing relevant multiples and other financial data which are updated on a quarterly basis and for appropriate company specific actions an additional source for locating comparables is in the prox proxy statement for a relatively recent m&a transaction in the sector as it Con contains excerpts from a fairness opinion an fa as the name connotes a fairness opinion ments on the fairness of the purchase price and the deal terms offered by the acquirer from a financial perspective furthermore equity research reports especially known as initiating coverage often explicitly list the research analyst views on the targets comparables and or primary competitors so there are a lot of different sources to really determine where the comparable companies what comparable companies are right so you have just reviewing them one more time you know you can research yourself and determine what uh comparable companies make sense you can also ask your investment bank and research equity research Department to see if they already have an existing list of comparable companies you can also look at the fairness opinion of recent transactions in m&a space or you can read other equity research reports provided by other investment banks that have initiated coverage on the respective Target to see what they consider to be the primary competitors for that company okay in step two you're now locating the necess Neary financial information some relevant sources for locating the necessary financial information to calculate key financial statistics ratios and multiples for the selected comparable companies are one the 10K the annual report the 10q the quarterly report the AK which is a current update updated report for whatever performance of the company there's also proxy statements which are documents shared to shareholders before you know a shareholder meeting there's equity research provided by investment Banks and there are Financial Services like Bloomberg and Thompson Royers which provide a lot of information really you know you'll probably be using a lot of Bloomberg but also you'll be looking into the 10K the 10q and the AK to really understand the current financial position of whatever company you're researching and at the same time the comparables okay so here's more a bigger summary of that so you know for income statement data such as sales gross profit EBA so on you can just look at the 10K and the 10 Q's uh for balance sheet information you can look at the 10ks and 10 Q's uh for share price data and current credit ratings you can go to the rated agency's websites or Bloomberg to really understand that information so there are different sources from different things and that's really what an analyst does like they're they're jack of all trades in the sense that they're going to be hopping between different information sources and bring them all together to really sum them up in a report and so that's really the value of the analyst now step three once the necessary information for each of the comparables has been located it is entered into an input page this input page is designed to assist the banker in calculating the key financial statistics ratios and multiples for the comparables universe the input data in turn feeds into output sheets that are used to Benchmark the companies let's now look at the different financial statistics and ratios so key financial statistics that are used in the comparable company's analysis are from a size perspective you have the equity value and Enterprise Value you have sales gross profit eida ebit from profit ility you look at gross profit ebit ebit from uh growth profile you look at the Historical and estimated growth rates return on inv on investment you look at return on investment cap invested Capital return on equity and return on assets and from a credit profile you can look at the leverage ratios the coverage ratios and the credit ratings and so we're going to go through all of these multiples and and ratios to give you the formulas so that you can refer to them when you are conducting your comparables companies analysis okay so first Equity value Equity value is is the value represented by a given company's fully diluted shares outstanding multiplied by the current share price when compared to other companies the equity value does not offer much more than a measure of relative size because of the capital structure bias and we'll talk about that because that's quite important so essentially Equity value is the share price times fully diluted shares and this is important it's not basic shares outstanding which is you know displayed on Google Finance under shares it's fully diluted shares so it's basic shares outstanding Plus in the money options and warrants Plus in the money convertible Securities and so we're going to be looking at how we can calculate the fully diluted shares in the following slides now this is something that I learned while reading the textbook for insight on alp's absolute and relative market performance the banker looks at the company's current share price as a percentage of its 52 we high this is a widely used metric that Pro provides perspective on on valuation engages current market sentiment and outlook for both the individual company and its broader sector and so I actually did this for you know the kind of um base metal sector within the Canadian market and so I took the target company which was first Quantum minerals and I compared it to you know comparable companies like silver wheat and Corp London um mining Corporation and Tech resources right and so what I did is I took their 52- we high and divided the the current share price by that 52e high and saw the percentage where does it stand relative to that performance you know one year out and so looking at that performance we see that for first Quantum minerals they are significantly below the percentage of 52 we high of the share price which is 69.5% and this gives you great insight into if the company is in line with this peers from a performance and current market value perspective or if there are individual things that are affecting the company's performance and therefore you should be spending more time on that right the ideal scenario is where you're comparing a Target company with companies that you've decided are the comparables and all of them are within maybe a five plus um kind of deviation uh percentage range right so you know if the average is 70 you know the percentage of of 52- we high is between 65% and 75% then we can say that both from a a market performance perspective and from a business and financial profile perspective they are very similar and that's what we're looking for this is actually quite a cool thing that I learned myself okay so now let's look at the calculation of fully diluted shares outstanding a company's fully diluted Shares are calculated by adding the number of shares represented by its in the- money options warrants and convertible Securities to its basic shares outstanding a company's most recent basic shares outstanding count is typically sourced from the first page of its 10K or its 10 q and so that's relatively easy information to find out but you need to calculate you know what is the dilutive effect of the in the money options and warrants and the in the money convertible Securities the incremental shares represented by companies in the money options and warrants are calculated in accordance with the treasury stock method the TSM those shares implied by a companies in the money convertible and Equity linked Securities are calculated in in accordance with if converted method or the net share settlement method so for the for the uh in the money options and warrants we're using the treasury stock method and for the in the money convertible Securities we can either use the ifon converted method or the net share settlement method the NSS method so we're going to go through each of those so for the treasury stock the TSM assumes that all tranches of the in the money options and warrants are exercised at their weighted average strike price with the resulting option proceeds used to repurchase outstanding shares of stock at the company's current share price in the money options and warrants are those that have an exercise price lower than the current market price of the underlying Company's stock so taking it slow what does this mean so essentially when we're for any baling we'll actually take a look at uh a real life example a company in its financial statements will display the different tranches the different levels of options that it has awarded or will award its employees in the future with a related strike price which is the exercise price for that respective option right so in this case you know we're looking at a company and this is the textbooks example where the current share price is $20 and so it has basic shares outstanding of 100 and in the money options of five of those five uh in the- money options the average strike price needs to be below it to be in the money right it needs to be profitable if it's out of the money if it's above that $20 then it doesn't make sense for you to exercise an option and pay above the current share price because you're losing money by then selling those shares in the open market you want to be exercising below the current share price and so that's what these options are in the money for right and their average weighted exercise price is $18 so they're making a $2 profit so when you're exercising those five um five options you're exercising them in realizing your profit right and so we can calculate that so the option proceeds from selling this so if you were to sell if you were to um if you were to sell these options so for the company from the company's perspective if you were to sell these five options at this price the company would receive $90 right and if you divide that by the current share price the current market value of those options and and the assumption is with the treasury stock method that the company okay okay the the obligation of the company when they have an option is that they have to sell a a share of that company to that employee or option holder at that respective price right so not the market price but the respective exercise price now the proceeds from that go to the company themselves because they're still selling a share but they're selling it at a lower price so they're not realizing as much the treasury stock method assumes that the proceeds from that sale are then divided by the current share price and it assumes that the company is going to use that proceeds to then reduce the existing share count so that whenever they exercise options it's not all all the time increasing the um the uh the basic shares outstanding they want to make it at least the least dilutive uh scenario possible because if not then you know you're diluting existing shareholders and that's really bad so the company uses that proceeds to then buy back shares at the existing level of $20 a share in this case and so in this case the $90 in proceeds from selling five shares at $18 a share is 90 and then you divide that by the current share price of 20 to to repurchase 4.5 shares now if there are five shares from in the money options and the company from the proceeds will buy back 4.5 then the net new shares from the options will only be 0.5 and that's the number that we add back now this is important and maybe you understand already but for those who don't once again so the treasury stock method assumes that the the shares that they issue the proceeds go to the company and they use all of those proceeds they don't hold anything back they use all of those proceeds to buy back shares in order to reduce the amount of shares issued and the impact of dilution on their existing shareholders and so in this case if the proceeds are $90 they divide it by the current share price to determine how much they can buy back and the difference is what we add to the fully diluted shares of standing count and so that's the treasury stock method okay now a frequent question is whether in the treasury stock me uh method calculation you include all outstanding options which includes vested and unvested or only exercisable options and this is important this is a huge question in Investment Banking interviews if our calculation will be used for a control-based valuation methodology I.E precedent transactions or m&a analysis we will use all of the options outstanding if our calculation is for a minority interest based valuation methodology so a comparable company's analysis we we will only use options exercisable so in this video we will only use exercisable options so what this means is that with the option schedule there are options that have been vested which are have already been uh issued and provided to the existing employees and some that are unvested that will vest over time which is an incentive for employees to stay on for a longer term not to just come into the company pick up options and then exercise them and leave so you know there's a vesting schedule they maybe in within three quarters or you know four quarters you know they vest out all the options that they were promised right and so when you are conducting in this video and in this chapter a comparable companies analysis you are only considering the options that have been vested in a scenario where the company's acquired that is a future obligation the unvested options and so you're assuming because the company will not continue anymore because it's being acquired then you're including those unvested options as well so that's why you know you either include or don't include depending on the analysis so for precedent transactions in the next video that I'll produce you you are including all outstanding options and this one it's only exercisable options okay so now let's look at a real example consider company the score which is uh listed on the Canadian Venture exchange under the ticker symbol sccr and it's this is It's 2017 q1 option schedule and so its current share price is uh 17 cents a share so and it's a relatively easy example because only one tranches is exercisable in the money right so you know the it's only profitable to exercise the you know 13 cent options uh and there are options outstanding of 3173 million and the options exercisable the ones that that have been vested are the same so in this scenario it's really easy because there are no unvested options at this trench so everything has been vested and it's relatively easy to calculate and it would be no different if we were using comparable or a precedent transaction analysis right and so that's all we have to do now we take that number so based on November 30th 2016 share price of uh 17 cents a share only the uh 13 cents a share trench is exercisable with all of those options vested now assuming the 3,1 73332 Shares are exercised at the 13 uh cents share net proceeds from that would be $412,500 to the company and assuming the company uses these proceeds to repurchase shares at the current at the currently traded at 17 cents a share the score will buy back 2,426 666 shares for net new shares from options of 746,000 and I'm just reading this and I feel that this is confusing and this is not helpful so I'm actually just going to pull out a calculator and do this calculation with you right here because I feel that this is very very important a lot of people they don't apply you know they understand the theory behind it but they don't really apply to a real world example so once again the company's exercising at this level all of these options because all of them have been vested in the comparable company's analysis right so the proceeds from selling shares at this price for the score the company itself we can just calculate that is 0.13 times 1 3,173 332 shares and so that will give us proceeds of 42,000 actually let me move the the calculator over here so you can see sorry about this um yeah so that will give us proceeds of that 42553 okay now we're dividing that by the existing share price of $17 as a share so we divide it by 17 to give us buyback the amount of shares that have been bought back that have been reduced from that issuance of 2,426 6666 shares so the score will buy back those amount of shares the difference between those two is essentially this number and this is the net new shares that are issued considering the treasury stock method okay that's pretty much it now the if converted method in the in the money converts are converted into additional shares by dividing the converts amount outstanding by its conversion price the convert is treated as equity and included in the calculation of the company's fully diluted shares outstanding and Equity value the equity value represented by the convert is calculated by multiplying the new shares outstanding from the conversion by the company's current share price accordingly the convert must be excluded from the calculation of the company's total debt so let's take a look at an example so if if $150 is in the money uh so there are 150 uh converts in the money we can divide the convert amount by the am the by the conversion price itself right so if there there's an amount outstanding of convertible Equity of $153 $50 and the conversion price on that convertible um Equity is $15 then we all we have to do is divide the amount outstanding by the conversion price to calculate incremental new shares of 10 and so we add that to fully downloaded shares and that's pretty much it so it's relatively easy to understand if converted now net share settlement so NSS is a newer feature in convertible bonds for converts issued with a net share settlement feature the issuer is permitted to satisfy the face value of an in the- money convert with at least a portion of cash upon conversion only the value represented by the excess of the current share price over the conversion price is assumed to be settled with the issuance of additional shares this results in less share issuance and dilution so if I have a convert that has a conversion price of $50 and the current share price is $60 the excess the $10 is what needs to be satisfied with new shares in this case you would divide the excess by the existing share price to calculate 0.167 new shares need to be issued in that case Okay so uh yeah so consider the example blah blah with $ 150 um dollar outstanding and a conversion price of 15 if the current share price is 20 then the extra $5 is the difference between the conversion price and the share price needs to be paid back with no net share settlement the if converted method would result in 10 new shares because you simply divide you know the amount outstanding by the conversion price to get 10 new shares with the net share settlement method the difference between the value of the incremental shares at the current share price and the value of the incremental shares at the conversion price is paid back in new shares so essentially we're taking so you you have the amount outstanding divided by the conversion price to give you 10 new incremental shares you you multiply that by the current share price to give you a total conversion value of 200 and then you take away the par value so 10 new shares multiplied by the conversion price itself which gives you 150 and the difference between that the excess is $50 in this case right and dividing that by the new shares that's the amount that is issued right so that's the that's the actual uh under the net share settlement method that would be the amount of shares issued and so as you can see it's less dilutive relative to the if converted we're just assuming that you know all incremental Shares are issued whereas with the net share settlement you are calculating the difference between the conversion price and the current share price and that's what's being paid back in total value terms right so we would multiply by the new existing shares so once again we have new existing shares of 10 okay the difference between the conversion price and the share price is $5 we can multiply 5 * 10 to give you 50 and then we divide that number by the existing share price to calculate the amount of incremental shares and so that excess value is what's being paid back under the NSS method okay so now Enterprise Value Enterprise Value is the sum of all ownership interests in a company and claims on its assets from both debt and Equity holders Enterprise Value is considered independent of capital structure meaning that changes in a company's capital structure do not affect its Enterprise Value so the Enterprise Value equals Equity Value Plus total debt plus preferred stock plus non-controlling interest minus cash in equivalence and really important thing here and the reason why Enterprise Value multiples are more frequently used than Equity value multiples is because it is considered independent of capital structure it includes both Equity value and debt right so when you're comparing different companies different companies have adopted different Capital structures and so by using the Enterprise Value you're you're conducting an unbiased comparison so it's an app apples to apples comparison whereas if you were to use an equity value multiple you would that Equity value is influenced by the inter the capital structure of the company so let's look at you know that unbiased nature so if a company raises additional debt the increase in total debt is offset by an increase in cash and equivalence so this formula so in any changes so say for example you add debt you know that increase in debt will be offset by the cash proceeds that originate from that new debt right so they would offset each other and therefore Enterprise Value would remain the same it's the same thing for a company that issues Equity to pay off de so if a company Issues new Equity you know to to so their Equity value uh increases so in this case so another example is if the company issues Equity to pay off debt the increase in equity value is offset by the decline in total debt so if the company issues Equity the equity value it would increase but but total debt would decrease because that equ that those proceeds are used to pay off total debt and so the changes would offset each other and therefore Enterprise Value would not change so in a scenario where you know total debt is is paid off for total debt increases those changes are offset and Enterprise Value Remains the Same and that's why it is considered independent of capital structure and a better way to compare different companies with different Capital structures now a big question is what is minority interest so looking at this calculation we have the non-controlling interest the minority interest that needs to be included in Enterprise Value so when a company owns more than 50% of another company us accounting rules state that the parent company reflects 100% of the assets in liabilities and 100% of financial performance of the majority own subsidiary on its its own financial statements Enterprise Value is used to create valuation ratios and metrics when we take say sales or eida from the parent company's financial statements these figures due to the accounting consolidation will contain 100% of the subsidiaries sales or ibida in order to counteract this we need to add to Enterprise Value the value of the subsidiary that the parent company does not own the minority interest by doing this both the numerator and the denominator of our valuation metric account for 100% of the subsidiary and this is why we add the minority interest this is a more technically Advanced question but also something important to understand and and the reason why we add minority interest so now comparing Equity value with Enterprise Value when building the comparable analysis and determining what ratios to use it is important to understand the difference between equity value and Enterprise Value multiples based on Enterprise Value are widely used by Bankers because they are independent of capital structure and other factors unrelated to business operations this helps in setting up a more fair environment to compare companies and I've already said this but this is really important to understand for those who maybe this is more of an introductory level kind of discussion okay so now let's look at size and the key financial data used to communicate size so there are two comments iida a widely used ibida is a widely used uh proxy for operating cash flow as it reflects the company's total cash operating cost cost for producing its products independent of financing costs and non-cash charges and ebit is independent of the tax regime and serves as a useful metric for comparing companies with different Capital structures so the important comments to take away from this are essentially the earnings before interest tax depreciation ammortization and earnings before interest in tax are different me metrics from a financial perspective that are used to really capture the operating cash flow and and a lot of Bankers prefer e but more than ebit from an operating cash flow perspective because it is independent of non-cash charges like depreciation and ammortization and both are independent of the financing regime the different Capital structures that companies might assume and so when you are you know when we're talking about Equity value versus Enterprise Value the important thing to remember is that for Enterprise Value multiples the lowest you can go on the income statement is ebit if you go beyond ebit what happens is you know if you're including the interest charges you know then the financing effect occurs right you know the interest expenses related to you know the different Capital structures of the company will impact the metric and therefore using a unbiased metric like e uh uh like Enterprise Value and using a metric like net income would not make sense so anything above ebit and including ebit is used as a uh multiple using Enterprise Value anything below ebit and not including ebit would be used with Equity value so Equity value to uh net income can be used because Equity value is impacted by the company structure and uh net income is also impacted by the uh company's capital structure because it's including the charges related to financing costs so that's really important to understand so some profitability metrics you know you can calculate the gross profit margin uh you know which is sales minus cogs divided by sales there's the ebaa margin so you divide EA by sales there's the ebit margin the ebit divided by sales sales and there's the net income margin which is a net income divided by sales there's also um the return on invested Capital which measures the return generated by all capital provided to a company ebit is used because it represents operating income for both debt and Equity holders so your return your roic would be ebit divided by average net debt plus Equity so that is the total Capital provided right so total Capital includes debt and equity and that is average net debt plus equity and the like like I said ebit is that measure that includes the op which represents the operating income that goes directly to ebit the debt and Equity holders so that's the calculation for that for return on Equity or it's net income divided by average shareholders equity and return on assets is net income divided by average total assets so these are all multiples that you might understand but once again just a quick review there there's also leverage metrics so you have the debt to iida or the leverage ratio which is debt divided by ibida there's also the debt to Total capitalization so you have debt divided by uh debt plus preferred stock plus non controlling interest plus Equity right and there's also the interest coverage ratio and this is an important multiple that a lot of people use and that is just IA either you can use iida you know the difference between ebit and kex which is a cash charge or ebit and divide that by interest expense to get your interest coverage ratio okay so now an important thing for the financial data is when you are using these numbers so when you're choosing to use uh you know iida or you're choosing to use the interest expense you know you have to use the last 12 months the LTM of that Financial metric right so U US public filers are required to report their financial performance on a quarterly basis including a full year report filed at the end of the fiscal year therefore in order to measure financial performance for the most recent annual or last 12-month period the company's Financial results from the previous four quarters are summed up right so it would be easy if you're doing an analysis at year end because you can just take the annual report and use those numbers but say for example you're doing a analysis in Q2 of that respective company's um you know fiscal calendar then you have to still take the last 12 months performance the annual performance in the last 12 months and use that measure to calculate those multiples and and the different metrics that you'll be using in your analysis and so to calculate the last 12 month multiple all you have to do is take the prior F prior fiscal year so you take the last annual results add the current stub so if it's in Q2 you add q1 and Q2 data and then you take away uh q1 and Q2 data of the last year right so say for example we're in currently in 2017 so imagine that we're currently in Q2 of 2017 we take the 2016 results for that company we would add the q1 and Q2 of 2017 performance for the company and then we take away the q1 and Q2 2016 performance of that company to calculate the last 12-month performance of that respective metric whether it's eida or ebit or you know interest expense or whatever it is okay so here's an illustration of that you know essentially you have the prior fiscal year which is you know q1 through Q4 of 2011 and this is assuming that we're in Q3 of 2012 right then we take the current stub in in 2012 so q1 to Q3 in 2012 we add that and then we take away q1 to Q3 of 2011 so it's relatively easy to understand okay and here's a real life example so this is JM P Group LLC this is a company that I'm actually looking at right now for research purposes uh they are a small cap Investment Bank in the US market and uh you know in so that we're calculating the last 12 Monon uh Revenue figure okay and so this is the annual revenue figure of the prior fiscal year so they made $134 million the current stub of this past quarter so this is q1 so q1 of 2017 they reported 24 million so I add that to this number and then the prior stub so the q1 of 2016 I take away this number to get La last 12 month uh revenues for this respective company JMP group of 120 million based in q1 of 2017 so we've exhausted this calculation you should probably understand it by now okay another thing calend calendarize the majority of US public filers report their financial performance in accordance with a fiscal year ending December 31st which corresponds to the calendar year end some companies however report on a different schedule maybe fiscal years ending April 30th any variation in fiscal year ends among comparable companies must be addressed for benchmarking purposes otherwise the trading multiples will be based on financial data for different periods and therefore not truly comparable and so really just to understand this and why there might be a ba bias say for example you're looking at a company that earns majority of its Revenue in Q4 right and then you decide that you want to compare Q4 numbers well if you're comparing a company that you know in so say for example this one company reports on you know year end December 31st and then the other reports year end April 30 30th so if you're looking at the first company you're saying okay their strongest quarter is in the final period right and then you're comparing that to that quarter for this company that would be Q2 not Q4 and that would be unfair you want to compare Q4 to Q4 data you want to compare Q3 to Q3 data and so on right and so you need to calendarize the the financial data and so to do so whatever metric you are using so in this case it's the next calendar year see y sales the sales figure you take the current the month number refers to the month in which the company's fiscal year ends so in this case we'd be calendarized the April 30th company right so if it ends in April 30th then that's that's the fourth month and so you you put in four times the company's for forward year uh sales annual sales you multiply that four by that sales figure and then you divide it by 12 and then you add the difference so 12 minus 4 so would be 8 times the next year's sales figure divided by 12 and add that up to calculate the next calendar Year's sales and so you've calendarized their sales data so that's pretty much it uh there are a lot of other resources that you can look in examples that want to do that right now cuz the presentation is always too already too long but here's a quick example so so say for example you know uh the current the annual um sales data for 2012 is $11,000 and for 2013 it's expected to be $1,150 and so if they report in uh in April 30th on April 30th then you multiply it by four divid by 12 plus 8 the difference between 12 - 4 multipli by the expected uh annual sales figure of $1,150 divided by 12 to get a calendarized sales figure of $1,100 okay so also you need to make adjustments for nonrecurring items so to assess a company's financial performance on a normalized basis it is standard practice to adjust fi uh reported financial data for nonrecurring items failure to do so may lead to the calculation of misleading ratios and multiples which in turn May produce a distorted view evaluation these adjustments involve the addback or elimination of one-time charges and gains and this is very important to make sure that your data is reflecting the normal business cycle typical charges include those incurred for restructuring events such as Tor plant closings and head count reduction losses on asset sales changes in accounting principles inventory writeoffs Goodwill impairment that's a big one especially if a company has acquired uh has made a recent acquisition they've they've reduced that the amount of Goodwill on their balance sheet or an EXT extinguishment of debt and losses from litigation settlements among others typical benefits include gain gains from asset sales favorable litigation settlements and tax adjustments among others so the reason you're adjusting for non-recurring items is because um it it is a bias towards the actual performance the real performance of the company's net income measure or you know ebit measure and so you want to make sure that when you're using that ebit you're assuming it's normalized business so adjusted for non-recurring items okay so when adjusting for non-recurring items it is important to distinguish between pre-tax and after tax amounts for a pre-tax restructuring char for example the full amount is simply added back to calculate the adjusted ebit and ebit up to calculate adjusted net income however the pre-tax restructuring charge needs to be tax affected before being added back conversely for after tax amounts the disclosed amount is simply added back to net income but must be grossed up by the company's tax rate before being added back to ebit and ebit and this is a little granular uh granular but it's important to understand if you are making adjustments a majority of them are pre-tax restructuring charges essentially when you are you know making making that adjustment to net income you have to uh tax effect that adjustment so if there if the company wrote down a pre-tax charge of $1,000 and the company's um tax rate is 30% then the adjustment to net income would be you know 70% of that so it would be $700 okay so that's important to understand so consider two one-time charges this is an example A 1 15 million pre-tax inventory write down and a restructuring expense of1 million pre-tax provided the banker is confident that these are non-recurring because that's a big question you have to ask yourself are these you know uh a non-cash items nonrecurring or are they recurring and there are some examples the best one is litigation fees for pharmaceutical companies that's part of doing business all they're always going in and out of court so you might not want to Define that as non-recurring right so there are some some again that's at the discretion of the banker and it's based on the experience of the banker so let's adjust ebit and eida and diluted EPS for this respective company right so both of these charges are pre-taxed and can be simply added back to eida right so for the inventory charge let's take a look here so where do these charges where should be these charges be reported so in the inventory rown would be in the Cog section and the restructuring charge has its own line item so it's already right over here and so you can see that we have a 10 million restructuring charge that's the number over there and there is a 5 million uh write down right so what we can do now is adjusted right so if there's a write down um our cost of goods would have increased and so we want to adjust that so we're lowering cogs so we're taking away the 5 million charge to make cogs 620 instead of 625 and for uh for the structuring charge you're looking at that 10 uh 10 million charge and you're taking that away to make it zero now and so essentially those two charges will impact your operating income your ebit right so you add the two which are total up to $15 million you add that to ebit and that means adjusted ebit is 150 instead of 135 and for adjusted eida you're now uh adding back depreciation and amortization plus dep uh ebit right just because we've we already calculated adjusted ebit so we all we have to do is add back depreciation amortization which in this case would be uh which would be 50 50 right to get adjusted ebit of 200 so once again so adjusting for nonrecurring items we have to determine whether either pre-tax or after tax in in this case both of the charges the inventory write down in the restructuring charge both pre-tax we're T the restructuring charge falls under the cost of goods sold and so we're taking away 5 million from the cost of goods because in in the case of an inventory rown our costs are increasing so cogs would be would have increased because of this charge so we're reducing cogs by 5 million and for the restructuring charge we're taking away the 10 million which is reported right over here and we're turning it to zero and so this 15 million combined non-recurring item needs to adjust ebit right so the adjusted ebit we have to add back that 15 million that was charged to to adjust ebit to 150 and so on a normalized basis the company would really be earning in this case $150 instead of 135 if they weren't reporting these non-recurring items okay so now let's look at the equity value multiples so price to earnings the ratio or the equity value to net income so EV to ni mult multiple which are both the same thing this ratio illustrates how much an investor is willing to pay for a dollar of a company's current or future earnings PE ratios are typically based on forward year EP EPS as investors are focused on future growth companies with higher pees and their peers tend to have higher earnings growth expectations so essentially from an equity value multiples perspective this is probably the most common and only multiple that will be used in the comparable company's analysis it's Equity value to net income right that's the better metric to use use so once you've calculate your Equity value which is you know total Equity plus uh total debt plus minority interest plus preferred stock minus cash and equivalence and you calculate your adjusted net income if there are any non-recurring items you can then calculate that multiple and you're using either the uh forward year the expected earnings so it's the uh the projected net income of the company or you're using the current last 12 month uh earnings of of that respective company okay so the two limits of using this multiple are one because it is referencing net income financing costs and thus the capital structure impacts the denominator so comparing companies with different Capital structures is unfair and if the company has low or zero earnings the measure is useless for analysis so these are the two downsides to eved ni the multiple itself is biased in in sense of financing costs and at the same time usually for you know kind of uh pre-prom right to report right they might report negative um net income and then the multiple itself is useless and so you have to go higher up on the income statement okay now from an entprise value multiples perspective given that Enterprise Value represents the interest of both debt and Equity holders it is used as a multiple of unlevered financial statistics such as sales eida and ebit and I talked about this so for Enterprise Value you're looking at ebit and above not below if you're looking below then net income would be uh impacted by financing costs and therefore you know you're not looking at a fair apples apples comparison so the two common multiples and the most common ones are e to iom and E to ibit so Enterprise Value to iida and Enterprise Value to ibit and these serve as a valuation standard for most sectors it is independent of capital structure and taxes as well as any distortions that may arise from differences in depreciation and ammortization among different companies okay so Enterprise Value to sales multiples or another multiple an Enterprise Vol multiple so evds is used also as a valuation metric although it is typically less relevant than other multiples discussed sales May provide an indication of size but it is not necessarily translate into profitability or cash flow generation both of which are are key value drivers and then there's also sector specific multiples using the Enterprise Value multiple so many sectors employ specific valuation multiples in addition to or instead of the traditional metrics previously discussed these multiples use an indicator of Market valuation in the numerator and a key sector specific Financial operating or production capacity statistic in the denominator and so we'll actually take a look at this so items that are affected by the capital structure you would use the U Equity value so you could do Equity value to book value Equity value to to cash available for distribution uh Equity value to discretionary cash flow and Equity value to to net asset value or net income and for Enterprise Value you can use um you know a broadcast cash cash flow so these are more uh sector specific measures and these are for more of the advanced things but at the very core at the foundation of the comparable company's analysis the most common Equity value multiple is equity value to net income and the most common Enterprise Value multiples would be Enterprise Value to iida Enterprise Value to ebit uh and sometimes Enterprise Value to sales but once again that is not usually dependent on most of the time so now step four we Benchmark the comparable companies so once the initial Universe of comparable companies is selected and key financial statistics ratios and trading multiples are spread the banker is set to perform benchmark analysis benchmarking centers on analyzing and comparing each of the comparable companies with one another in the Target the ultimate objective is to determine the targets relative ranking so as to frame valuation accordingly so you Benchmark the financial statistics and ratios and then you Benchmark the trading multiples so financial statistics and ratios would be you know the the ibida margin the uh the uh gross profit margin you know the interest coverage ratio all these kind of financial statistics that determine the in independent strength of the company and then the trading multiples would be the EV to iida EV to ibit multiples that you're comparing and so those benchmarks you know you can then calculate the means and and medians of those to really then get a better sense of you know what what the the expected Benchmark is right so in step five you're determining the valuation so the the trading multiples for the comparable companies serve as the basis for deriving an appropriate valuation range for the Target right so we're we're spreading and we're you know benchmarking the financial statistics and trading more multiples but you know we're using the financial statistics to draw Insight with regards to the comparable companies when we're determining valuation we're using trading multiples not financial statistics and so the trading multiples serve as the basis for deriving an appropriate valuation range for the Target the banker typically begins by using the means and medians of the most relevant multiple for the sector whether it's EV to IA or price to equity priced earnings sorry to extrapolate a defensible range of multiples the high and low multiples of the comparables Universe provide further guidance so in this case the that the ex textbook provided you know you look at they were comparing the uh Enterprise Value to ibra the EV to ibra multiple range and they saw that you know based on you know their discretion they decided that you know the closest comparable company is company a and so they were on the lower end of the range so 6.5 time x so it' be 6.5 times the EV on multiple whereas you know the uh another close comparable would be company C and that's up on the higher range and so in this case you know the banker decides that you know the company they're not going to give a specific number they're going to give a valuation range and so it ranges between 6.5x and 7.5x E okay and also you have the high and lows of each of of each of the comparable companies although those are more of you know guidepost more than actual real valuable projections because it would not be beneficial for the banker to project 5.5x e IA or it would be just you know very um unrealistic to project 8.5x okay and so now we can take those multiples and imply a valuation based on that multiple so consider the 6.5x to 7.5x multiple range for 2012 expected eida to calculate implied Equity value we sub subtract net debt of 500 million from Enterprise Value then divide by fully diluted shares outstanding to get the implied share price this methodology can be used for Ev to um last 12month eida and EV to the expected 2013 ibra as well so essentially the moment so we've gone through the process let's let's just quickly summarize we've gone through the process we've determined you know we've learned about the company then we've determined what the key comparable companies are which are the most relevant we've then calculated the financial ratios and inputed the multiples and then we've benchmarked those ratios and calculated the averages and implied that there is a range between 6.5x and 7.5x multiple range for Ev to ibaa right and that can be based on the multiple for the existing ing LTM the last 12 months it can be based on the expected ibida of the next following fiscal year of 2012 or 2013 so you can base it on projections as well now once you multiply and you decide hey let's go right in the middle so let's go 7x Eva for 2012 the expected 2012 EA multiple we can then imply that Enterprise Value range and we can imply that Enterprise Value then take away 500 so the case of last 12 months for or the last 12 months if you IAM right if we're range between 7 and and 8x you know we can take away the $500 uh the 500 in uh net debt to bring it back to equity value to get our implied Equity value between 900 and 1,500 and we divide by fully diluted shares to get an implied share price range of $9 to $11 and so that's how we take that Enterprise Value projected Enterprise Value and we bring it down to the most realistic projection number number that we want our client to see which is the implied share price of the company okay and so we can also imply it based on other things like price uh price to earnings so consider a PE multiple range of 12 to 15x you know the 2012 expected net income it is much simpler to get the final implied share price because in this case you know we're we're using this is the equity value to net income multiple right so in this case you know it's much easier because we're not using Enterprise Value we don't have to convert it back so if we use an equity value multiple then when we're implying our valuation all we have to do is you take that range and then divide it by fully diluted shares to get the implied share price range as well so this is you know the different ways that we can you know project the valuation of the company and finally this is the last two slides of the video so what are the over a quick overview what are the advantages of the comparable company's analysis A it's market-based information is used to derive valuation is based on the actual Market data and thereby reflecting the Market's growth and risk expectations to day it's all also relatively easy and uh to measure and compare other companies to your target company it is quick and convenient it doesn't take that long and there are not that many assumptions to make other than you know choosing the right comparable companies and it is very current so the valuation is based on prevailing Market data which can be updated on a daily or intraday basis now what are the disadvantages in addition although it is Market based and the information is derived from current expectations those expectations might be off they might be very biased because we're in a boom uh boom or bus cycle and so if we are at the highs or the lows of a respective market then the current valuation of that company and its comparables will give off a a very biased number which might not be correct also there might be an absence of relevant comparables so there are no true pure play comparables out there so really you're making the assumption that if I compare Coca-Cola to Pepsi that you know like at the end of the day I'm basing Coca-Cola's valuation on Pepsi even though Pepsi might have a Foods a much larger Foods Division and its performance might be derived from other markets than Coca-Cola so once again it's really really important to select the correct Universe of comparable companies but at the same time it's almost impossible to select the perfect companies there's also a potential disconnect from cash flow in many markets you know investors in the current share price don't really reflect the fundamental value if you were to conduct a discounted cash flow analysis but again it's part of the toolkit and you're you're providing a range for your client so this is another way to confirm a relative range for the client so you can also use a discounted cash flow model in line with the comparable company's analysis to provide that range and at the same time there might be company specific issues that will create deviation in the valuation range so once again if you're comparing Coca-Cola to Pepsi maybe Pepsi is going through some management changes or it's facing some lawsuits that might not be impacting you know Coca-Cola because it's a company specific issue and so in that case even though the companies might be very similar there are issues that will deviate the valuation away from what is considered once again a pure play comparable and so that is again one of the big disadvantages so that's pretty much it I've been talking for a very very long time so please please please like the video subscribe to the channel if you do have any questions please comment below I will be sure to get back to you this is what I love I love talking about this stuff you know I am going into the investment banking space and I love the SE and as always I have a lot of other videos covering U you know initial public offerings Investment Banking you know the discount in cash flow analysis you know that's my favorite kind of methodology to use so I'm going to make be making a lot more videos on that as well so if you do like this video and you found it helpful please subscribe to the channel for more and if you have any questions please comment below and that's pretty much it guys thanks for watching thanks for sticking it all through and have a nice day thank you