Definition of Comparable Multiples
Comparable multiples, or multiples of peer companies, are a common method for stock valuation. To use comparable multiples, you need to identify the most similar companies and apply their average multiples to the company in question.
Definition and Examples of Comparable Multiples
Comparable multiples, or peer companies, are used to find the valuation multiple for stock analysis. You search for the most similar competitors, calculate the average valuation multiple, and apply it to the stock you are analyzing. The analysis of comparable multiples using ratios is also known as relative valuation.
There are two common methods for using comparable multiples: previous transactions and public companies. Public comparable multiples use the current trading price of similar companies. Previous transactions, or private comparables, are the latest merger or acquisition prices of similar companies.
How Comparable Multiples Work
Financial data and information services, such as Bloomberg or FactSet, which are used by Wall Street professionals, present comparable multiples in an easily understandable way. All you need to do is enter the stock ticker of the company and get your evaluation. However, for individual investors, you don’t have to spend thousands of dollars on these services to perform comparable multiples analysis. You can find all the information you need from basic financial websites like Yahoo! Finance or Morningstar.
Let’s see how to do this using Home Depot (HD) as an example. Yahoo’s main page shows five competitors of Home Depot: Lowe’s, Lumber Liquidators, Floor & Decor Holdings, and Leslie’s. Let’s gather some basic information about each of the companies and then decide how to perform the comparable multiples analysis.
We’ll use the price-to-earnings (P/E) ratio as the valuation multiple for our analysis. The debt-to-equity (D/E) ratio is used to assess the amount of debt each company has (the higher the number, the more debt; generally, any number above two indicates that the company carries heavy debt). The profit margin is used to evaluate how profitable the companies are. Growth is the earnings growth of the last quarter, and market capitalization (the total value of the company measured by the share price multiplied by the number of outstanding shares) is used to assess size.
Before you begin your analysis, you may already have a certain bias towards some comparable multiples. Most people know that Home Depot and Lowe’s are the two big players in this industry – and the comparable multiples prove this. Lowe’s and Home Depot have market capitalizations in the hundreds of billions of dollars, and the closest competitor among the other four is only 13 billion dollars.
The four smaller companies also have much higher growth rates, and of course, higher P/E multiples (except for Lumber Liquidators).
At this stage, it makes sense to eliminate the four smaller competitors. You can use Home Depot’s financial data, recent news, and other research, or even the industry code to find additional competitors if you need to, but comparable analysis is rarely perfect.
Typically, we apply the average comparison multiples to Home Depot to calculate the value. In this case, there is only one good multiple – Lowe’s – and Home Depot’s multiple of 23.33 is close enough to Lowe’s multiple of 21.02 that the difference is not significant. Especially since Home Depot has higher margins and growth and less debt.
Let’s look at another example to understand the process using Wells Fargo (WF):
Company P/B Profit Margin Growth Market Cap
J.P. Morgan Chase 1.87 37.18% 155% $474 billion
CitiGroup 0.78 30.12% 487% $143 billion
Bank of America 1.36 31.84% 161% $344 billion
U.S. Bank 1.76 32.51% 188% $83 billion
Average 1.44 32.91% 248% $261 billion
Wells
Wells Fargo 1.06 22.12% Not Available $180 billion
The debt-to-equity ratio was removed this time because it is not as useful for banks with organized distributed balances. Note that the growth figures are very high because they use the pandemic profit numbers from 2020. As there is no number for Wells Fargo due to its loss in the last quarter, we will exclude growth from our analysis.
The price/book value ratio of Wells Fargo is the second lowest among the five banks. This is due to its profit margin being approximately eight percentage points lower than that of the least competitor. Wells Fargo’s poor profit margin should impact your analysis.
If you only look at the multiples, you would immediately think that Wells Fargo is unfairly valued. But by putting the multiple in context, you can make a decision based on whether Wells Fargo’s profit margin will be able to rise to the same level as the other large banks on the list. If that happens, we can calculate a potential price target by multiplying book value per share for Wells Fargo by the average multiple of 1.44. If Wells Fargo reaches $60 per share, that implies a 35% increase from its current price of $44.33.
Main Takeaways
Comparative values are used to evaluate a stock based on the market values of comparable companies that are traded on a stock exchange or that have recently been sold in a merger or acquisition process. Comparative valuation is also referred to as relative valuation. It’s important to place comparative multiples in context by also considering other financial metrics.
Source: https://www.thebalancemoney.com/what-are-comps-5204859
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