The Complete Investment Banker Extract

7/21/2019 The Complete Investment Banker Extract

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IntroductionTrading comps is a relative valuation technique that uses public company information to infer avaluation on a target company. The valuation works on the premise that similar or comparable

companies tend to be valued on a similar or comparable basis on the public markets.The method is often used for:

Buy side M&A

Sell side M&A

Fairness opinions

Initial public offering (IPO) valuations

Share repurchases

Follow on financing

LBO valuations

The method is very popular with investment bankers and research analysts. Clients are alsovery receptive to the valuation technique as the concept is very digestible and is not steeped intechnical jargon.

However, there are some issues that analysts should be aware of:

The quality of the analysis is dependent on the quality of the comparable inputs. Theprocess is inherently flawed as no two companies are truly comparable.

Trading comps is often heavily reliant on accounting information. As the initial chapters of

this manual have highlighted, accounting numbers are prone to manipulation and are ofteninconsistently applied within the peer group as well as internationally.

Trading comps will normally use forecast information to perform the valuation. Thisinvariable means relying on equity research. This presents no problems if all thecomparable companies are covered. However, equity research houses do not cover allcompanies. Trading comps can therefore become an increasingly spurious exercise ifequity research is unavailable.

Loss making companies often dont lend themselves well to trading comps valuation due tothe common reliance on the earning metrics.

The valuation does not include a control premium. This is not a flaw as such, just a

characteristic of the valuation.

Tradingcomp

arables


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Trading comps a four step structured approach

Comps process overviewThe trading comps process can be structured into four steps. Cadbury plc will be used as a case study

comparable company. The four step process will be applied to Cadburys numbers in order to calculate acomparable multiple.

The trading comps process essentially collects information in relation to a number of comparable companies(the comparable universe). The majority of this information will be financial in nature. However, narrativeinformation will also be collected in order to develop a more rounded picture of the markets the comparablesoperate in.

The process makes use of valuation multiples. A valuation multiple is simply an expression of a companysmarket value in relation to key statistics. The statistics are assumed to be driver of the companys value.There must be a logical relationship between the statistic and the market value. The most commonstatistics used are earnings metrics.

There are two basic types of multiple:

Enterprise value multiples and Equity value multiples

Enterprise value multiples capture the full value of the claims of the capital providers on the company. Therelative metric (the denominator of the multiple) must also therefore relate to the enterprise. For instance, ifthe metric is an earnings metric, then the earnings metric must be an enterprise value level metric. That is,the earnings metric is claimed by both debt and equity capital providers. Enterprise level metrics arerevenue, EBIT or EBITDA for example.

Equity multiples capture the equity investors claim on the company. The metric must again be consistentwith the equity claim. The relevant earnings metric is normally net income, as this is claimed or owned byequity capital providers.


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The financial information is then used to calculate valuation multiples such as:

EV / Revenue

EV/ EBIT

EV/EBITDA

P/E

These multiples provide a basis for comparison of the companies in the comparable universe.Companies will trade on different multiples. There will always be reasons for differences in the tradingmultiples. It is an analysts job to make sure that the differences in trading multiple levels are understoodand are justifiable.

A trading comps model will also calculate a plethora of financial ratios that will be used to support themultiple justifications.

At this stage analysts will have a number of important decisions to make:

Which comparable companies should be relied on for the target valuation?

What type of multiple is most appropriate to value the target?

How does the target company fit into the comparable universe?

Is the target a company that should be valued at a premium or a discount to the comparable universe?

What multiple range should be applied to the target?

Once these very important questions have been addressed, the analyst will then have an appropriate rangeof multiples with which to value the target. The multiple range is then applied to the financials of the targetto arrive at a valuation. The valuation is driven off the decisions and analysis derived from the comparableuniverse.

What are the key drivers of a multiple?There are generally three key drivers of a multiple: The quality of earnings or cash conversion

The risk profile of the earnings

Growth rates

These drivers are fundamental to understanding what lies behind a multiple and why some companies tradewith multiples that are at a premium or a discount in relation to the rest of their comparable universe.

The three drivers are derived from a simplified DCF valuation model. Whilst the following equations are notessential front of head knowledge, they do assist in understanding how and why multiples behave in aparticular way.

The ideas behind the drivers are based on the premise that the enterprise value is the present value of thecash flows that belong to debt and equity capital providers. This cash flow is better known as free cashflow to the enterprise or free cash flow to the firm (FCFF). This is the basic principle of a DCF valuation. Ifwe assume, for illustration purposes, that future free cash flows will grow at a constant rate (g) in perpetuity,then the EV is as follows:

)(

1

gWACC

FCF

Therefore EV is the discounted stream of cash flows that are claimed by debt and equity holders.


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Growth (g) is driven by the rate of reinvestment of earnings (b) and the return on capital generated on thereinvestment (r).

Where:

FCF Net operating profit less adjusted taxes: (NOPAT) x (1 the reinvestment rate (b))

g Growth rate, where growth is driven by the rate of reinvested earnings (b) and the return on

invested capital (r): g = r x bWACC Weighted average cost of capital (See Chapter 13)

This idea can now be converted into a multiple by dividing both sides of the equation by EBITDA.

)(

1

gWACC

EBITDAFCF

EBITDA

EV

=

With this equation the drivers of the multiple can be conceptually extracted:

)( gWACC

EBITDAFCF

EBITDA

EV

=


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The drivers can be further broken down by examining the components of each variable. Thus whenexplaining the behaviour of a multiple, an analyst should be prepared to consider the drives below. Theexamination can focus on earnings margin development, working capital management, capex spend inrelation to D&A, risk free rates etc. Any one of these variable could explain a multiples behaviour inrelation to its peers.

)(1

gWACC

EBITDAFCF

EBITDA

EV

=

WACC

Cost of equity

= Rf + (EMRP)

Cost of debt

= (Rf + CMRP) x

(1-Tc)

Risk free rates

Rf

Equity market risk

premium

EMRP

Beta

Risk free rate

Rf

Credit market risk

premium

CMRP

Tax shield

Tc

g

= b x r

Reinvestment

rates

b

Return on

invested capital

(r)

Free cash flow:

Revenues X

Operating costs (X)

EBIT X

DA X

EBITDA X

Changes in NWC X/(X)

Operating cash flow X

Less:

Capex (X)

Tax (X)

Free cash flow X

It is a simple model based on simplistic assumptions. However the purpose is more focused on thedevelopment of a thought process that examines as many variables as possible; rather than just stating amultiple is high because the market has strong expectations. That is far too thin an explanation whenconsidering issues on a professional level.


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Step 1 Comparable universe identification

The choice of the comparable universe is the bedrock decision for trading comps. Get the comparable

universe wrong and the valuation will be wrong. The key idea to think about when selecting the comparableuniverse is that the selection is attempting to replicate the characteristics of the target company through aportfolio of companies. The portfolio the comparable universe will be used to construct a comparablemultiple for valuation purposes. That multiple needs to reflect the cash, risk and growth characteristics thatare indicative of the target company.


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The comparable universe choice will consider:

When constructing the comparable universe, it is the quality of the comparable that counts, not the quantityof companies included in the universe. A comparable universe of 20 companies is likely to have asignificant amount of statistical noise. Often the comparable universe is made up of seven to nine highquality comparables.


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A comparable universe summary is often included in pitch books. The summarybelow uses moon phases or pies to illustrate comparability. The diagram canprove to be an excellent visual communicator to support a comparable universedecision. The shading on the moon phase illustrates the degree ofcomparability the redder the moon the better the comparability.

Get the comparable universe wrong and your trading comp valuation will bewrong. Make sure you investigate your comparable universe thoroughly anduse all the resources that are available to you:

Talk to the right people deal and industry teams Review previous presentations

Recent prospectus

Company websites often include competitor references

Equity and credit research reports sometimes include comparableuniverses to support their comps work

Standard Industry code (SIC) run

Bloomberg descriptions

Bloomberg relative value function (RV)

FACTSET and Bloomberg comps functions

Competition section in 10K / Prospectus

Other sources: Hoovers in-depth records

Be careful with the data sources comparable search functions. These compsearch functions are basic search algorithms. The search functions will notanalyse the comparable universe in any great detail. They tend to be purelysector driven functions.

Assistancein

choosingthe

comparab

leuniverse

Pitchbook

comparable

universesum

mary


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Step 2 Collecting the comps data

With the comparable universe now selected, sufficient information must now be collected to allow the

calculation and justification of the comparable multiples.Cadbury plc will be our comparable case study company. At this stage most analysts will not be makingany choices about which type (EV/EBITDA, EV/EBIT or P/E) of multiple to calculate. This type ofdecision-making is best done when all of the comparable information has been collected.

For the purposes of this illustration however, we will collect sufficient data for an EV comparable multiple.Collecting data for an EV comp should provide sufficient information to calculate an equity level multiple too.

Enterprise valueEV has been discussed a number of times in this manual. EV is the cost of buying the right to the whole ofan enterprises core cash flow. It is the full takeout value of the firm in an M&A situation.


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Enterprise value can be described as having three components:

Total EV the value of all of the entitys activities. This includes associates, joint ventures, investmentsand non-core assets.

Operating EV the value of all operating activities (excludes non-operating assets usually investments,and sometimes associates and joint ventures)

Core EV focuses on the core operations of the entity.

Most valuation multiples will focus on a core EV, as we will examine later.


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Calculating EV Equity value component

Equity value is also called market capitalisation or market cap. The mathematics of the calculation isrelatively straight forward, although the practicalities can be more involved.

Market capitalisation = current share price x number of shares outstanding (NOSH)

The current share price can be picked up from:

The Financial press The Financial Times, Wall Street Journal etc

Data service providers Thomson One, FACTSET, CAPIQ

Company websites

The difficulty with the basic market capitalisation calculation is the number of shares (NOSH). The NOSHwill be published in the latest set of financials. However, this is unlikely to be sufficiently up to date for

Sometimes companies will use a different currency in their financials to thecurrency their stock trades in. The share price will therefore need to be translatedinto the base currency of the financials.

Analysts must translate the share price using the latest available spot exchangerate. If the spread on the exchange rate is reasonably narrow, the mid-priceexchange rate is acceptable.

Sharep

rice

denominations


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valuation purposes. Companies can take a number of weeks to report financials. So even at best thereported NOSH will be out of date.

There are two options available to the analyst:

1. Rely on a data provider for a NOSH number. Care must be taken here; data providers may not have themost up to date information in their databases. It is a useful exercise to cross-check the data providers

NOSH against another source. This NOSH method is acceptable in many circumstances. However, ifthe NOSH has been subject to recent changes and the comp is being used for a live deal or for numbersthat will be subject to client review, reliance on a data provider may not be acceptable.

2. A more precise NOSH number can be derived by rolling forward the NOSH from the latest reportedfinancials. The NOSH is rolled forward using stock exchange announcement for any equity issues orbuy backs. These roll forwards are normally reserved for deal comps or instances where there is a lackof trust in the data service numbers.

Key pricing and NOSH information can be accessed through the Bloombergcompany description screen.

Key strokes:

Ge

ttingNOSHon

Bloomberg


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An additional difficulty with the NOSH calculation is the sheer amount of terminology that surrounds thenumber. In a set of financials there are a number of NOSH variants such as:

Authorised the number of shares the company is legally allowed to issue

Issued the number of shares issued by the company (includes treasury shares)

Outstanding the number of shares issued net of treasury shares

Weighted average this is a NOSH number used purely for EPS calculations

Analysts need to initially focus on the outstanding number of shares for the basic market cap calculation.


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Cadbury comp

The Cadbury basic market capitalisation calculation:

Cadbury plc

Currency

Current share price 5.58

52 week high 5.62

52 week low 4.78

NOSH (m) 1,361

m

Current share price 5.58

NOSH (m) 1,361

Market capitalisation 7,594

It is a useful idea to present 52 week share price highs and lows as a benchmarking exercise. The shareprice dates would also be noted in practice. Market capitalisation is the major component of EV. It istherefore very useful to get a feel for the EV number in relation to the market cap trading performance. Thedates will give a feel for market sentiment. In this example we can see that Cadbury is trading very near its52 week high and hence the market cap will be near its maximum.

Some companies have more than 1 class of equity that will feed into the marketcapitalisation calculation. We are not talking here about an entity havingcommon and preferred shares, which are 2 different types of security.

Different classes of share are created when companies wish to issue a certainclass of share to a particular group of investors. These shares are commonlycalled Class A and Class B shares. There is normally a voting distinctionbetween the classes. For instance, sometimes the Class B shares may haveinflated voting rights for instance 10 votes for every share held. Hence keyinvestors are provided with greater control over the companys actions.

Many companies list dual class shares. Ford Inc has 2 classes of share. TheB shares are family held and allow the family to control 40% of the vote whilstholding only 4% of the equity. Berkshire Hathaway, Warren Buffets investmentcompany, has 2 classes of shares. The B shares in Berkshire have 1/30thof theequity interest of an A share and 1/200thof the voting power.

Dualclass

sh

ares


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Documenting your work is vital. Your superiors will review your work and willwish to know the source of your data and any relevant background detail. Gooddocumentation will make the review more efficient and you will spend a lot lesstime justifying your work. Mistakes will be found and resolved quickly if thereviewer can see the background detail.

Excel makes documentation very straightforward through the use of comments.Insert a comment (Shift + F2) in your work and record:

your name (this should be set up on your profile)

the source of the data

note any cross referencing/checking

any adjustments made to the raw data

any thoughts relevant to the number

any issues that need further clarification

If in doubt insert the comment

An ADR is a certificate that provides US investors with ownership of shares innon-US companies. ADRs trade in the US equity markets. ADRs are issuedby US depository banks. The major depository banks are:

JP Morgan

Citi Deutsche Bank

Bank of New York Mellon

ADRs were first introduced by JP Morgan in 1927 on Selfridges equity.

The share ownership the ADR represents is usually expressed as an ADR ratio.That is, 1 ADR would represent x number of shares in the foreign entity. Theprice of an ADR normally tracks the underlying share in relation to the ADR ratio.

From a market capitalisation calculation perspective, the analyst risk here isdouble counting. ADRs are a representation of underlying NOSH. Theseshares are already issued and outstanding. They are held by the depositarybanks. The banks are issuing a certificate on the underlying. Therefore it

would be a double counting error to calculate the market capitalisation on NOSHand the ADR (in relation to the ADR ratio).

American

Depo

sitory

Rece

ipt(ADR)

D

ocumentatio

n


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The Documentation CA Tip above notes the use of =FDS coding as a source ofshare price information. =FDS codes allow FACTSET data to be incorporated

into Excel financial models. This allows up to date information to be streamedinto the workbook.

The coding syntax is straightforward:

=FDS(Ticker,ITEM(SDATE,EDATE,FRQ))

ITEM indicates the FACTSET data item

SDATE start date

EDATE end date

FRQ - frequency

The syntax is very useful to know for regular coding. However, the FACTSETExcel add-in includes the =FDS code builder. The code builder has similarfunctionality to the Excel function wizard.

=FDS code builder set up:

Step 1 Go to the FACTSET Excel link menu and Lookup > FQL FormulaLookup

Step 2 Choose library

Step 3 Choose a category, then browse for a formula or search usingkeywords

Step 4 Highlight a formula, then click Select

Step 5 Specify the dates and optional arguments

Step 6 Click OK to bring the formula into the spreadsheet

Step 7 Modify the formula to =FDS syntax

Step 8 Select the FACTSET Excel link then select =FDS Codes > RecalcAll

UsingtheFACTSET

=FDS

codeb

uilder


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Calculating EV fully diluted equity value componentA public market comp will often anticipate the impact of potentially dilutive securities on the market cap.These potentially dilutive securities are equity claims on the company. Potentially dilutive security issuesare:

In-the-money (ITM) equity options

ITM convertible debt

ITM convertible preference shares

ITM equity options

The fully diluted equity value calculation anticipates the exercise of ITM equity options. ITM equity optionshave 2 impacts on the diluted equity value and therefore the EV:

There is an increase in the NOSH which reflects the issue of new shares on the assumed exercise of theoptions.

In order to exercise the options, the option holders will have to pay the exercise or strike price of theoption. This is a cash inflow for the company. The increase in cash flow will reduce net debt.

The impact of ITM equity options can be calculated in 2 ways using:

The treasury method or

ITM buy-out cost method

The two methods will give the same answer.

Information requirement =FDS coding syntax

Closing share price =FDS(A1,P_PRICE(0))

52 week high =FDS(A1,P_PRICE_HIGH_52W(0))

52 week low =FDS(A1,P_PRICE_LOW_52W(0))

NOSH =FDS(A1,FF_COM_SHS_OUT(ANN,0,,,RF))

=F

DScoding

(shareprices

an

dNOSH


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Many analysts make significant mistakes with the options note. A lack ofunderstanding or appreciation of the terminology is the main cause of error.

Key option terminology:

Exercise or strike price the price at which an option can be exercised. WAEP weighted average exercise price.

In the money An option is in the money (ITM) if the exercise price isbelow the current market price.

Out of the money An option is out of the money (OTM) if the exerciseprice is greater than the current market price.

Exercise or vesting period is the period the option must be held beforethe option can be exercised.

Outstanding an option is deemed outstanding if it has been issued.

Exercisable an option is exercisable if held beyond the exercise or

vesting period. The option is said to have vested.

The key column to pick up in an options note for the diluted equity valuecalculation is the outstandingoptions column.

Interpretingtheop

tionsnote


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The treasury methodThe treasury method works on the assumption that the proceeds from the share option exercise will be usedto buy back shares on the market at full market value. Therefore the net dilution from the share optionexercise is net of this buyback.

The following steps are required for the treasury method calculation. The numbers below refer to the

following Cadbury example:

1. Calculate the proceeds from the share option exercise (280.07m).2. This involves identifying the share options that are in the money (ITM).3. Given the disclosures in the financials the ITM determination is normally calculated with reference to the

weighted average exercise price (WAEP)4. The proceeds = number of options ITM x the exercise price5. These proceeds are used to buy back shares at full market value = proceeds current share price

(50.19m shares)6. Therefore the net dilution = number of shares issued through option exercise buyback = 62.57m

50.19m = 12.38m shares net dilution

The dilution can be expressed in terms of the net impact on EV = 12.38m shares x current share price =69.05m. This net impact on EV comprises two forces:

The impact on market capitalisation of the new shares issued as a result of the share option exercise(number of new shares issued x current market price) and

The cash proceeds received as a result of the option exercise which will increase the cash number andreduce net debt (number of new shares issued x exercise price).

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