The main purpose of equity valuation is to estimate a value for a firm or security. A key assumption of any fundamental value technique is that the value of the security (in this case an equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day. There are three primary equity valuation models: the discounted cash flow (DCF), cost and comparable approaches. The comparable model is a relative valuation approach and is explained in more detail below.
Comp Models Introduced
The basic premise of the comparables approach is that an equity’s value should bear some resemblance to other equities in a similar class. For a stock, this can simply be determined by comparing a firm to its key rivals, or at least those rivals that operate similar businesses. Discrepancies in the value between similar firms could spell opportunity. The hope is that it means the equity being valued is undervalued and can be bought and held until the value increases. The opposite could hold true, which could present opportunity for shorting the stock, or positioning one’s portfolio to profit from a decline in its price.
There are two primary comparable approaches. The first is the most common and looks at market comparables for a firm and its peers. Common market multiples include the following: enterprise value to sales (EV/S), enterprise multiple, price to earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF). To get a better indication of how a firm compares to rivals, analysts can also look at how its margin levels compare. For instance, an activist investor could make the argument that a company with averages below peers is ripe for a turnaround and subsequent increase in value should improvements occur.
The second comparables approach looks at market transactions where similar firms, or at least similar divisions, have been bought out or acquired by other rivals, private equity firms or other classes of large, deep-pocketed investors. Using this approach, an investor can get a feel for the value of the equity being valued. Combined with using market statistics to compare a firm to key rivals, multiples can be estimated to come to a reasonable estimate of the value for a firm.
The comparables approach is best illustrated through an example. Below is an analysis of the largest, most diversified chemical firms that trade in the U.S.
|EASTMAN CHEMICAL (NYSE:EMN)|
|COMPARABLE COMPANY VALUATION|
|Comparable Company||Price||Enterprise Value (EV)||Revenue (TTM)||EPS (TTM)||Free Cash Flow (FCF) per share (2012)||EV ÷ Rev.||Price ÷ Earnings||Price ÷ FCF||Gross Margin (TTM)||Operating Margin (TTM)|
|Eastman Chemical Company||$80.92||$17,310.00||$8,588.00||$3.38||$4.41||2||23.9||18.3||22.70%||8.70%|
|Dow Chemical (NYSE:DOW)||$36.06||$57,850.00||$56,514.00||$2.17||$1.24||1||16.6||29.1||16.60%||7.90%|
|Air Products & Chemicals (NYSE:APD)||$106.87||$28,130.00||$10,200.00||$4.68||$1.14||2.8||22.8||93.7||26.40%||13.00%|
|Huntsman Chemical (NYSE:HUN)||$18.06||$8,290.00||$10,892.00||$0.41||$1.50||0.8||44||12||16.10%||1.70%|
|Average of Selected Multiples||$34,866.00||$24,321.00||1.7||24||34.3||21.60%||7.90%|
Looking at Eastman Chemical, it immediately becomes clear that it is one of the smaller among major diversified firms. The raw data used to compile the primary comparable data includes raw enterprise value, revenue and profit figures. The three primary multiples suggest that Eastman is trading above the industry average in terms of EV/revenue, and slightly below the average in terms of P/E, the most basic tool to investigate the multiple that the market is placing on a firm’s earnings.
Eastman’s P/FCF multiple, a more nuanced profit multiple that is intended to look at true cash flow by removing some of the subjectivity of reporting earnings, is well below the average, though the high level for Air Products & Chemicals (P/FCF of 93.7) looks suspect and may need an adjustment. A key part of a valuation model is to look at potential outliers and see if they need to be reconsidered or outright ignored. Leaving out Air Product’s suspect multiple puts the peer average at 19.4, which leaves Eastman still below the average, but much less so than if all multiples are considered.
The other consideration is Eastman’s income statement profitability compared to rivals. Both its gross and operating margins are above the industry average. Overall, the company looks reasonably valued, at least based on the above information. But, as detailed above, other considerations are still needed, such as a valuation by projecting growth and profit trends over the next couple of years, and really looking at the details of earnings, free cash flow, and margins to make sure they are accurate and truly representative of the company. The same goes for each individual company that makes up the comparable universe.
A final consideration is to look at market transactions. For instance, back in 2012 DuPont sold a large part of its chemical division, its performance coatings segment, to private equity giant Carlyle Group (Nasdaq:CG) for $4.9 billion and an estimated multiple of eight times EBITDA. This multiple applied to Eastman, or simply multiplying Eastman’s EBITDA of $1.7 billion over the last 12 months, would suggest an enterprise value of nearly $14 billion, or slightly below the current enterprise value that the firm is trading at. This would indicate that Eastman is overvalued by this metric, but as explained in the next section, this may not be the case.
It is important to note that it can be difficult to find truly comparable companies and transactions to value an equity. This is the most challenging part of a comparables analysis. For instance, Eastman Chemical acquired rival Solutia in 2012 in an effort to have less cyclicality in its operations. DuPont’s performance coatings business is highly cyclical, so it should likely have sold at a lower valuation. As detailed above, the free cash flow multiple for Air Products looks suspect in the analysis, meaning further work is needed to determine what adjustments should be made.
Additionally, using trailing and forward multiples can make a big difference in an analysis. If a firm is growing rapidly, a historical valuation will not be overly accurate. What matters most in valuation is making a reasonable estimate of future market multiples. If profits are projected to grow faster than rivals, the value should be higher.
It is also worth noting that, of the three primary valuation approaches, the comparable approach is the only relative model. Both the cost approach and discounted cash flow are absolute models and look solely at the company being valued, which could ignore important market factors. On the flip side, the stock market can become overvalued at times, which would make a comparable approach less meaningful, especially if comps are overvalued. For this reason, using all three approaches is the best idea.
The Bottom Line
Valuation is as much art as science. Instead of obsessing over what the true dollar figure of an equity might be, it is most valuable to come down to a valuation range. For instance, if a stock trades toward the lower end, or below the lower end of a determined range, it is likely a good value. The opposite may hold true at the high end and could indicate a shorting opportunity.