Do Your Own Research

Insightful analyst, fund manager and accountant lan Robertson shares his tips to help investors understand what questions to ask when making investment decisions.

August 4, 2023

Comparative chaos

The simplicity and clarity of multiples-based valuation approaches mean that they are the most commonly used techniques in the small and mid-cap space.

The most column inches seem to be applied to the numerator with much gnashing of teeth on the ‘Adjustments’ made to Earnings and EBITDA that near universally improve these figures and make valuations more attractive.  However, in small and mid-cap research there can be just as much confusion and diversion with the selection and presentation of comparators.

In this blog we set out to help the reader understand and avoid some of these issues and to make better use of analyst reports and valuations.  Some might choose to view what we describe here as tricks of the trade, but experience has taught us that they are just as likely to be the result of mistakes, ignorance or laziness.

In essence, it is a valuation of (proxy) cashflows

With a comparator-based multiples valuation we are striving to get a better idea about what the share price or share price range should be by comparing against other businesses, taking into account business dynamics, cashflows, risks, returns and growth – remembering that we are valuing ‘earnings’ as a proxy for cashflow.

It is not absolutely necessary for the comparator businesses to be operating in the same area, but it does make things clearer and easier to validate and verify. It is, however, rare in published equity research for an analyst to consider a similar set of dynamics, returns, margins and growth from another sector, perhaps unsurprisingly as research is written by sector specialists. The result of focusing too tightly on companies in the same area could be that all we get is a ranking of valuations – and just end up buying the seemingly best-value stock in the most overvalued sector.

Elephant in the room – comparator choices are based on multiples, not on facts

It would be naïve to suggest that the selection of comparators in sell-side research is never based on achieving the highest price target, rather than finding the ‘right’ price target. A key, and generally obvious, giveaway is that the company that is the subject of the note lies at the bottom of the range of multiples provided in the valuation.

The right number of comparators

There is no correct number of companies for a comparator-based valuation. It is reassuring to see a dozen comparators, but this is no guarantee that it is a complete list of comparators. Or maybe the analyst has simply used the ones for which the forecasts were easy to find or most supportive of his or her case.  As we work our way through the issues, it should become clear that choosing a dozen comparators, because of the work required to do it properly, could be just as bad as having only one.

That said, it could well be that there is only one relevant comparator, or perhaps one so similar as to make others irrelevant.

Location, course and destination

For companies that are on a journey or that are in the process of transformation, it is normal for comparators to be selected that mark the end point of the process.  We buy company B because it is transforming itself into something that looks like company A.

This makes prima facie sense as we are looking forward to what the company is to become and buying the shares in anticipation of the transformation.

However, in doing so, we must consider the factors of time and execution risk. Furthermore, there is no guarantee that our destination will be the same or as relevant when we get there.  For example, setting out a target multiple for a new entrant based on a dominant incumbent’s premium valuation is not appropriate if the new entrant causes the monopoly to become an oligopoly – where in the long term both companies’ multiples will in fact be lower.

Of course, our company may not be alone on this journey and the best comparators are actually likely to be its travel companions / competitors – not the company they are all trying to emulate or become.

We should not forget that the comparator target companies may themselves be on a journey, with a rating itself raised by lofty expectations, by one-off poor results or with figures distorted by ‘adjustments’.

Same industry, but different part of the value chain

Commonality of industry is often wrongly placed ahead of commonality of business model. For example, rather than considering the multiples for small metal component manufacturers as comparators for widget manufacturers, the multiples of distributors and retailers of widgets are used instead.

It makes no sense attempting to apply the EV/EBITDA multiple of a manufacturer with 25% operating margins with those of a reseller with 7% margins.  But when everyone tells the world that they ‘provide solutions’, it is easy to be lured into seeing similarities that do not exist.

Same industry, same products, just part of larger group

Most small and mid-caps find themselves competing against divisions of far larger companies, usually international companies.  Simply because parts of these larger groups are competitors does not mean that the entire group is an appropriate comparator. In most cases the larger company’s value is driven by something completely different within it.

No point in using estimates we know are wrong

The forecasts for the comparators could also be wrong or out of date. This can be a particular issue around reporting season as forecasts get revised up and down with the mixing of metrics of companies that have and have not updated the market.

Larger companies better known, more visible

It is well understood that larger companies tend to have higher valuation multiples than smaller ones.  A number of reasons are put forward for this: stronger positions in their market; better businesses; greater visibility into numbers and track records; better management; greater liquidity in share trading etc. All of these reasons will serve to provide better operational returns and reduce the risk of investing. To a certain extent when looking at small and mid-cap companies, the size premium issue is unavoidable. However, the general (but not universal) size premium should not be ignored – even though it is difficult to measure.

For a small or mid-cap company, it is generally easy to select a mix of larger companies to provide a set of higher comparator multiples.  In analysts’ defence, this need not be a deliberate attempt to mislead, it is just that the information and forecasts for larger comparators may be more readily available and sometimes it can be better to present a comparator that is known to the reader than an obscure one that leaves the reader numb or wondering if they know anything at all.

The issue of larger companies having higher multiples presents further opportunity to introduce error and distortion into multiples-based valuations when used alongside another confusing ‘technique’, applying weightings of multiples.

Weightings on multiples

Calculating market cap-based weightings or averages for sets of comparator multiples in valuations has an innate appeal. Calculating something feels like it is doing something of value.

Given a list of comparators, an intelligent investor is going to make judgements as to whether the company being analysed justifies a higher or lower P/E or EV/EVITDA than each of the companies on the list.  So unless the selection of comparators is a representative sample of the sector (as the investor understands it) there is limited merit in mixing all the paints together.

It can be particularly misleading with market cap weighted figures when the highest multiple provides the highest market cap and has the highest weighting.

An alternative approach that has gained some currency is to show the median, although we struggle to see what looking at the one in the middle really adds either.

Comparison between markets

In a global economy, it makes sense to look internationally for comparators. We should be cautious about drawing too direct a comparison as there are many reasons why multiples may vary between very similar companies across different stock markets.

The most obvious economic reason for a higher multiple in one country and one currency than another country and currency is that of the discount rate or cost of capital.  Lower discount rates should mean higher multiples.  Differing tax regimes may also make a significant difference when looking at pre-tax earnings measures.  Perhaps the most commonly cited accounting reason is that treatment and use of share-based payments may differ.

Other differences may be due to fundamental economics or local investors having a particularly favourable or unfavourable, temporary or permanent, attitude towards certain sectors.

Takeover multiples and private deals

It is not uncommon for analysts to look to M&A or other transactions as sources of comparator valuation metrics.

There is clear merit in looking outside public markets for validation of data, but this can be dangerous where the visibility into exactly what is being purchased and why can be severely limited. Hidden issues can lie with both the acquiror and the acquiree, with assets such as tax losses potentially irrelevant to public market investors but hugely attractive to corporate buyers with profits available to offset.

In takeover transactions, the price includes a control premium – something that can only be transferred across to public market equity analysis if we are arguing that the company is going to be taken over.  In such cases, the relevant multiple may well be the multiple of the acquiror if the acquiror can only make earnings-enhancing deals.

Venture capital financings can be a useful source of higher valuation metrics, although quite how credible they are is a matter of opinion, particularly if there is no way for the VC investors / purchasers to invest in the company.  It is not so much a case of different markets as different planets if there is no visibility into the VC’s justification for its pricing.

This leads us to the wider issue that the identity of the acquiror / investor can be relevant.  It would be wrong to assume rationality and due process on their part, or that they will continue to be an active acquiror / investor.

Same industry, same products, different business model

While the final products purchased by end customers may be similar, and their experience and view of them little different, the means by which they are produced and reach the end customers can be very different.

The use of outsource services and manufacturers and licensing/franchise business models make this increasingly important.  The valuation metrics appropriate for a virtual mobile phone operator that may be little more than a brand will not be appropriate for a mobile phone operator than owns towers, runs the network and call-centres, does the billing and may even have its own technologies.

Using P/E captures the impact of investment through its inclusion of depreciation and amortisation.  Using EBITDA effectively ignores the cost of investments in intangibles and tangibles assets alike.

Much of the costs of the networks etc for the outsource virtual provider come through as cash operating expenses, and so are reflected in the EBITDA figure.  Much of the costs of the networks for the traditional providers are depreciation and amortisation, and so are not reflected in the EBITDA figure.  For both business models, these costs are reflected in the earnings per share figure.  Other things being equal, the P/Es should be broadly similar but the EV/EBITDA for the traditional operator should be higher. Throwing a few outsourced business models into the EV/EBITDA mix is therefore an easy way to enrichen the mix.  That said, given the increasing use of outsourcing and different asset finance structures, it is an error that is difficult not to make.

Stages of cycle and growth

Even companies that do the same thing in the same markets can have different appropriate valuation multiples.  Where they are at different stages of their growth or perhaps investment/reinvestment cycle, we can find ourselves with the same EV/EBITDA vs P/E question as we have with comparing business models.  One company may produce the same output from old written-down kit (with no depreciation charge) that will only last a few years more as a comparator with new kit and a full depreciation charge.  The relative patterns / paths of EV/EBITDA and P/E may highlight this.

Tax matters

Looking at the EV/EBITDA vs P/E, it is evident that the tax charge is going to be relevant – most notably with it the issue of comparability and sustainability.

A company with a permanently low tax charge should have a higher EV/EBITDA than an equivalent company with a normal tax charge.  A company that is delivering strong earnings or earnings growth by virtue of utilising tax losses that will soon come to an end should have a lower P/E than one that delivers this with a constant tax charge. It is well understood that many sell-side analysts flounder incoherently when it comes to tax, and with that in mind any bias one way or another in comparator / metric selection here is likely to be more by luck than intent. But it is worth remembering that these issues exist.

Financing matters too

Earnings growth that is driven by paying down debt and reducing the interest charge can, like tax losses, only get you so far. But the impact of ‘interest’ runs deeper.

In general, higher and better-quality EBITDA growth will mean higher EV/EBITDA multiples.  And in general, higher and better-quality earnings per share growth will mean higher P/E multiples.

However, the ‘benefits’ of the higher and better-quality EBITDA growth accrue to the owners of the enterprise – ie, it includes the debt owners / lenders as well as the equity shareholders.  EBITDA growth using expensive debt can be of no use to equity investors if the value goes out of the door in interest payments.

Pointing to high EBITDA growth and high EV/EBITDA is no guarantee that a high P/E is deserved – in fact, if the interest structure is too punitive it could merit a lower P/E.

Getting the right numerator right

The balance sheet structure does not simply impact the valuation through the level of debt.  Surplus assets can have a considerable impact on how P/Es and EV/EBITDAs can and should be used.

If we consider a company with a significant pile of excess cash that investors anticipate will be distributed to shareholders, then the market cap and the share price have two elements – the excess money and the ongoing business. The earnings come almost entirely from the ongoing business.  The cash contributes an interest income.  The P/E is distorted upwards.  Such companies are everywhere, and they make for dangerous comparators.

Of course, the EV-based approaches don’t have this problem.  The excess cash and other assets (if you are lucky) are stripped out in calculating the enterprise value. Typically, this is done automatically by the data provider (Bloomberg, FactSet etc), with net cash being the figure that is deducted.

But what if the excess cash isn’t excess cash at all but required working capital.  At its most basic level, you could see this as like the cash in the tills at a retailer (bricks and mortar type), but at another level for a manufacturing business that may require funds to pay for components.

In many sectors most businesses would cease to function if their cash piles were removed yet many analysts still seem happy to strip cash from the EV.  In its most extreme case the oil exploration or biotech with products only in trials or development the misrepresentation can be significant.

Taking out the cash required to run the business lowers the EV and makes a company look cheaper on an EV/EBITDA basis.  It is some small comfort that the error is generally applied to all comparators and so the directional impact is not always upwards for the company that is the subject of the note.

A word on debt

In calculating the enterprise value, it is normal practice to look at the value of debt at face or nominal value, ie £100 owed is valued at £100.  However, this need not be the case with troubled companies where lenders might be happy to get £90, or substantially less, for their £100 owed.  Finding the value at which debt trades or is viewed by lenders can be troublesome, if not impossible.  That said, in the context of this blog, if the debt is trading at a visible discount, then it is time to move on.

Calendar year versus financial year

In rapidly changing end markets, it is important to ensure that comparators’ different year-ends do not mean that we are comparing one company’s peak trading year with another’s downturn year – for example, year ends January 2022 and December 2022 are both FY22.

In businesses that have seasonal sales cycles and therefore seasonal balance sheets, care needs to be taken in assessing if there are any excess cash holdings and when comparing with similar businesses with different year-ends. Some do so for presentational purposes while others do so because it makes sense operationally to wrap up the year after the busy season when the cash is in.

Once again, the retail sector serves as a good example, but cash balances can also be under-representative simply because of large receipts or payments around the year-end – often seen with contracting firms and those with large exposure to public sector budgets.

A way around these issues is to adjust the earnings figures to calendar years, but this does not really capture the differentials and still leaves cash figures unadjusted. In such cases, there can be merit in looking at the interim cash position and in considering whether a figure somewhere in between might be more appropriate.

How many valuation nudges make a red flag?

It is clear there are plenty of opportunities for multiples-based valuations to go astray. However, their simplicity and clarity mean that they remain our preferred way to examine the valuation of small and mid-cap stocks.

Most of what we have described are, with the exception of wholly unsuited comparators, nudges to the valuation. However, they are nudges that tend to be in the same direction and a tally of them should be kept when examining any multiples-based valuation.  Too many nudges in a valuation can cause us not only to doubt the final price target but also the wider intent and content of the analysis as a whole.

Ian Robertson

irobertson@progressive-research.com

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