JAMES P. WESTON: Hi. Welcome back to Finance for Nonfinance Professionals. In this video, we're going to talk about valuation by comparables. In the last couple of videos, we've been talking about valuation by discounted cash flow. And comparables are a little bit of a different-- comparables or multiples are sort of a little bit of conceptual different approach. So practitioners do sometimes valuation by comparables or what they say is comps. And so what are the comps? Comparable transactions or prices-- you see this a lot sometimes in commercial real estate transactions. Sometimes you see it in small business transactions. And sometimes you see it on putting values on things where the price is sometimes very uncertain. And so I always like to talk a little bit about valuation by comps right after talking about valuation by discounted cash flows. Valuation by comps is quick, easy, back of the envelope. It's why you see practitioners do it a lot of times, but it can also be very dangerous. And so I want to talk about what are the trade-offs in using valuation by comps versus valuation by discounted cash flows. OK. So some of the assumptions for doing valuation by comps is that you can identify things that really are comparable-- close comparables. If I say that I sold a house in Des Moines for $500,000, and I compare it to a house that I just sold in Houston for $200,000, are those really comparable transactions? Are they in the same neighborhood? Do they have a similar school district? Do they have a same lot size? Are they the same zoning? Right? There's a lot of different facets of those two assets that might make them hard to compare. On the other hand, two houses built by the same developer in the same development in the same town in the same street in Sugarland might be very comparable because they're essentially the same house. They're almost next door neighbors. So we have to be very careful in identifying close comparables. The other thing is that we have some value relevant ratio. A lot of times we'll use things like earnings multiples, or price to earnings ratios, or accounting ratios, and we'll talk a little bit about that. And we have to be understanding that the market values those comparables similarly. OK. So let's talk about comparables and use. The idea here is you've got some ratio, the price over some attribute, maybe it's sales or earnings or equity or assets. And you're going to use that ratio price to assets or price to sales times your attribute-- what is true about your firm-- and you're going to use that to price your asset. So you're going to use basically a different PE ratio or some ratio in order to do the comparable transaction. OK. So some types of attributes that we use, that practitioners use in practice, might be a price-to-earnings ratio or an earnings yield or earnings over the price or dividend yield, the string of dividends or dividend growth, divided by price, return on assets, which is a return on equity sometimes people use, or return on investment or capital sometimes people use, which is an accounting ratio. How much profit are you making over some accounting item like assets or equity or net income? And a lot of times you'll see EBITDA multiples, earnings before interest, taxes, depreciation, amortization, an accounting profitability measure divided by something like assets or price or-- OK. Let's talk about P/E ratios. Those are one of the more popular price-to-earnings ratio. You see analysts talk about this a lot. If you go to Yahoo Finance, and you pull up information about a stock, a lot of times you'll see P/E ratios. And you'll be like, what is that? So it's the price to the amount of accounting earnings that a company makes. And so what does that ratio tell us? Well, it's how much $1 of current earnings costs if I go and buy the stock. OK. So if a company trades at five times earnings or three times earnings or 20 times earnings, what does that tell us? That tells us how much I'm going to have to pay in the market to buy $1 of current earnings. And so we could think about doing valuation by comparables. And let's just walk through an example. I think that's probably the easiest way to see it. Let's think about the Lowes Corporation. Lowes Corporation is a big home goods store in the United States. And let's think about how we might value that based on a comparable. So a good comparable for Lowes maybe is Home Depot, which is in the same market. It's also a home goods store. They sell lumber and drywall and things to make your home better. Both stores do. And so let's think about it. If I look at Home Depot, and Home Depot had earnings of $6.80 per share last year. Based on their market price, they were trading at the P/E ratio of 25. I then look at Lowes' earnings of 246, and I say, what should the stock price for Lowes be based on a P/E ratio of Home Depot of 25? And so what I'll do, in order to figure a comp value based on the P/E ratio for Lowes is I'll say what's the comp value for Lowes? I take the P/E ratio of Home Depot, multiply it by the earnings of Lowes, and what I should get is the P, right, because the earnings in the denominator. Cancels the earnings in the numerator. That leaves me with the P. That P is the comparable price for Lowes. So if I do that based on Lowes' earnings, and Home Depot's, that's the comparable P/E ratio, a comp P/E ratio, I get an implied market price. The shares of Lowes ought to trade at around 61.60. OK. Now if I-- this is a nice example because I can actually go to the stock market and see what Lowes actually trades for. What are investors actually buying and selling shares of Lowes for? If I do that, I see that the price, the market price of Lowes is $74 a share, which is about 20% different from our valuation by comps. So you can see it-- which is good, right? The valuation by comps doesn't give me like $10,000 a share or $0.02 a share. It actually gives me something ballpark around where Lowes is trading, if you consider 20% plus or minus 20% close enough. And for a lot of things where there's a huge amount of uncertainty, a 10%, 20%, 30% difference might be close enough or ballpark or back of the envelope. But a 20% difference in valuation from the market price to the valuation by comps might be enough of a difference, enough of a wedge, that you should at least approach valuation by comps a little bit more cautiously, which is going to be my main advice to you. OK. So there are other comps that we could use besides P/E ratios. A lot of people use the return on equity or return on assets, net income divided by assets, or equity accounting ratios, or return on invested capital, dividend yield, how much dividends are driving off the stock, or the P/E ratio divided by the growth in earnings, the PEG ratio you'll see sometimes. And, again, the same example that we looked at for the P/E ratio would come through exactly the same way. You would just use a different attribute, ROA, or the dividend yield or the PEG ratio. Measuring comps is a little bit tricky. We often rely on historical averages. Should you do the last 12 months or the previous three years? You've got to make some qualitative decisions that are sometimes hard to make and, frankly, a little ad hoc. What do you do with negative prices or negative earnings? Usually we just drop those out of the analysis, which is also a little sketchy and a little ad hoc. But, again, what we're doing is sort of a quick and dirty back of the envelope valuation using some of these ratios. OK. Both DCF and valuation by comps can provide useful information. There's nothing wrong with doing valuation by comps, but my advice is always do a DCF valuation along with it. The comp can give you a good idea of whether you're in the right ballpark or whether it's vaguely comparable to other transactions. And if both executed correctly, if you really do have good comps and the market values those comps the same way, both valuation techniques can be equally valued. But my advice is to always rely on DCF. The comps can lead you in the wrong direction because they're abused sometimes in practice. They involve a lot of ad hoc and sort of qualitative decisions to make. Both require forecasts, but DCF is more appealing in theory. And I think a little bit more accurate, even though it requires a little bit more work than the sort of quick and dirty back of the envelope valuation by comps. So my advice is always, if you want to do valuation by comps, that's fine. Put it next to a DCF valuation to give you-- kind of to round out the valuation for you, but always be a little bit more cautious when you're looking at comps than when looking at DCF.
