Presented by

Elmira Partovi
lecturer in
Lectorial 7:
Comparable Analysis
Accounting
and Finance

Email:
Elmira.Partovi
@uwe.ac.uk

Department of
Accounting,
Economics and
Finance
Questions Addressed
• What is the value of a company?
• Finding out how investment bankers use ratios to glean insights
from financial statement.
• Uncovering how much companies are worth using valuation
ratios.
• Stacking up companies against each other using profitability
ratios.
• Detecting how well management uses shareholder money with
efficiency ratios.
• Tracking how quickly a company drives its bottom line with
growth-rate analysis.
Reading
• Krantz, M. and R. R. Johnson. (2014) Investment Banking for
Dummies. Chapter 8 and 9
 Approaches to Valuation

- Intrinsic valuation, relates the value of an asset to its

intrinsic characteristics: its capacity to generate cash flows
and the risk in the cash flows. In it’s most common form,
intrinsic value is computed with a discounted cash flow
valuation, with the value of an asset being the present value
of expected future cash flows on that asset.
- Relative valuation, estimates the value of an asset by
looking at the pricing of 'comparable' assets relative to a
common variable like earnings, cash flows, book value or
sales.
- Contingent claim valuation, uses option pricing models to
measure the value of assets that share option characteristics.
4
Corporate Securities as Contingent Claims on Total Firm Value

• The basic feature of a debt is that it is a promise by the

borrowing firm to repay a fixed dollar amount of by a
certain date.
• The shareholder’s claim on firm value is the residual
amount that remains after the debtholders are paid.
• If the value of the firm is less than the amount promised to
the debtholders, the shareholders get nothing.
 Debt and Equity as Contingent Claims

Payoff to Payoff to
debt holders shareholders
If the value of the firm is If the value of the firm is
more than $F, debt holders less than $F, share
get a maximum of $F. holders get nothing.

$F

$F $F
Value of the firm (X) Value of the firm (X)
Debt holders are promised $F. If the value of the firm is
more than $F, share
If the value of the firm is less than $F, they get the
holders get everything
whatever the firm if worth.
above $F.
Algebraically, the bondholder’s claim is: Algebraically, the shareholder’s claim
Min[$F,$X] is: Max[0,$X – $F]

6
Claims depend on the value of firm (X)

-If X<=F where X is the value of the firm and F is the value
of debt:
+ Debt holders’ claim = X
+ Share holders’ claim = 0
- If X>F:
+ Debt holders’ claim = F
+ Share holders’ claim = X-F

7
Valuation Multiplies
Multiples covers three main areas:

1. How possible is to forecast a company cash flows?

2. Why is one company’s valuation higher or lower than its competitors in the
market?
3. Are the company strategy and missions good enough to bring more value for
them than its peers?

What Are Multiples?

• The main multiples are:

1. Price –to- earning ratio (P/E)

2. Enterprise-Value-to- EBITDA
P/E Ratio
o The P/E ratio tells investment bankers how much investors are willing
to pay for a claim to a dollar of a company’ earning. Hence, the
higher P/E ratio, the more richly valued a company and its stock are.

o The price–earnings (P/E) ratio is the most familiar valuation measure

today.

P/E Ratio =

P/E x EPS = price of share

Example: The market price of an ordinary share of a company is $50. The earning
per share is $5. Compute price earning ratio?

P/E= 50/5
P/E =10

•
 Rationales for the Use of P/E
Ratios
• Earning power is a chief driver of investment value. Earnings per share
(EPS), the denominator of the price–earnings ratio, is perhaps the chief
focus of security analysts’ attention.

• The price–earnings ratio is widely recognized and used by investors.

• Differences in price–earnings ratios may be related to differences in

long-run average returns, according to empirical research
Drawbacks to P/E Ratios
Drawbacks based on nature of EPS.

• EPS can be negative. The P/E ratio does not make economic sense
with a negative denominator.

• The components of earnings that are on-going or recurrent are

most important in determining intrinsic value. However, earnings
often have volatile, transient components, making the analyst’s task
difficult.

• Management can exercise its option within allowable accounting

practices to distort earnings per share as an accurate reflection of
economic performance. Falsifications can affect the comparability of
P/E ratios across companies.
Accounting Issues with P/E
Ratios
• In calculating a P/E ratio, the current price for publicly traded
companies is generally easily obtained.

• Determining the earnings figure to be used in the denominator,

however, is not as straightforward. Two issues are

o The time horizon over which earnings are measured, which results
in two chief alternative definitions of the price–earnings ratio.

o Adjustments to accounting earnings that the analyst may make so

that P/E ratios are comparable across companies.
Price to Book Value Approach
• In the P/E ratio, the measure of EPS value is a flow variable relating to
the income statement. By contrast, the measure of P/B value is the
book value per share, which comes from the balance sheet.

• Naturally, book value per share attempts to represent the

investment that common shareholders have made in the company, on
a per-share basis.
Rationales for Use of P/B Ratio
• Because book value is a cumulative balance sheet amount, book
value is generally positive even when EPS is negative. We can
generally use P/B when EPS is negative, whereas P/E based on a
negative EPS is not meaningful.

• Because book value per share is more stable than EPS, P/B may be
more meaningful than P/E when EPS are abnormally high or low, or
are highly variable.

• As a measure of net asset value per share, book value per share has
been viewed as appropriate for valuing companies composed mainly
for liquid assets, such as finance, investment, insurance, and banking
institutions. For such companies, book values of assets may
approximate market values.

• Differences in P/B ratios may be related to differences in long-run

average returns, according to empirical research.
When the Price-to-Book is
Preferable to P/E?
• When dealing with a young company:

o When companies are just starting their performance, they may have
little amount of earning or even losses.

• When a cyclical company is in a downturn:

o Earning of some companies rise/fall by large degrees along with the

ups and downs of the economy.

• When dealing with a capital-intensive business:

o Some companies require to do a significant investment in plant,

property, and equipment. They do usually investment more tan their
companies value.
Putting a Price on Profitability
• Enterprise value to EBITDA ratio simply comes from:
o Earning
o Before
o Interest
o Tax
o Depreciation
o Amortisation
• It is same as operating net income/profit if there are no exceptional
items of income or expenditure shown in the income statement.

EBITDA= Net Income + Tax + Interest + Depreciation and

Amortization
Putting a Price on Profitability
• Enterprise value is the market value of a company with its net debt added back.
So;

Enterprise value = Market value – Cash and Short-Term Investments +

Total Debt

• The enterprise value/EBITDA ratio is often used along with the P/E by
investment bankers to evaluate how pricey a company is.

• The enterprise value/EBITDA ratio tells investment bankers the total value
placed on a dollar of the company’s earning adjusted items that do not cost
cash.

• Market value is the company’s stock price multiplied by its number of shares
outstanding.

• Enterprise value to EBITDA is more trustable than market value, although

market value is the most common way for investors to get information about a
company’s value.

Note1: EBIT is an another figure in the financial statement shows the operating profit. It is
Example
Below table shows a financial data for Company A:
Liquidity Multiplies
• The liquidity ratios are used to examine the liquidity position of the
company/business.

• It enables to recognize whether short-term liabilities can be payed out from the
short-term assets.

• In shows whether a company has enough working capital to carry out routine
business activities.

• Where to use liquidity?

1. To size up how much of a company’s financial resources are tied up in debt:
2. To determine whether a company can keep its head above water financially
3. To see how much of a bite borrowing takes from profits.

• Key ratios in liquidity are:

o Current ratio
o Quick ratio (acid test)
Liquidity Multiples- Current
Ratio
• Current ratio shows the relationship between the current assets and current
liabilities in a company.

Current Ratio =

• High current ratio shows under trading and over capitalisation in a company.

Note 1: Current assets includes raw materials, stores, spares, work-in progress, finished
goods, bills receivables, cash.
Note 2: Current liabilities includes payable within one year, other liabilities payable within a
year, instalments of Term loan, etc.
Liquidity Multiples- Quick
Ratio/Acid Test
• Quick ratio shows how quick you can pay the expenses if your income suddenly
goes to zero.

Quick Ratio =

• The higher the quick ratio, the more the company has in liquid assets that could
be used to pay upcoming bills.
Example
If the current assets and current liabilities of a company are $4,000,000 and
$2,000,000 respectively,
Current Ratio = 4,000,000/2,000,000
Current Ratio = 2

A total current assets of a company is $500,000 and its total current liabilities is
$350,000. This company has $200,000 of stock, $100,000 of cash and $200,000
of debt. Calculate the quick ratio?

Quick ratio = (500,000 – 200,000) / 350,000

Quick Ratio= 0.8571
Debt to Equity
• Debt (Leverage):
o The essence of debt is that you promise to make fixed
payments in the future. If you fail to make those payments,
you lose control of your business/investment.

• Equity:
o With equity, you do get whatever cash flows are left over
after you have made debt payment.

• Interpreting debt-to-equity ratios needs good understanding of

the company’s structure and sources.
• The higher the debt-to equity ratio is, the greater proportion of
a company’s finance comes from debt.
Example
Company A provides the below information to show its debts and equity’s figures:
Profitability Ratios
• Profitability ratios help to:
o Examine the profitability of a company
o To find out the ability of the firm to meet its debt (liquidity)
o To assess how efficiently the managers of a company uses the available
sources.
o Investors can gain what they expect to gain from their investment in that
company

• Beginners in the Investment Banking use the “Margin” or “Profit Margin” to

represent a company’s profit.

• Profit margin is nothing than a number of financial ratios that are designed to
illustrate the company’s profitability.

• The key ways to measure the margins are via “Gross Margin”, “Income from
continuing operations margin” and “net margin”.

• The fundamental ratios of profitability can be seen in income statement. It is a

powerful financial statement that includes all the company’s main forms of
income and expenses.
Why Gross Margin is Not so
Gross?
• A company’s gross margin is gross profit divided by total revenue.

• Gross margin, is the money that left and can be used to pay overhead and
provide a return to shareholders.

• Investment bankers use the gross margin to evaluate how profitable a company
is before paying overhead costs, which are more manageable than direct costs.
Profitability Ratios- Income from
Continuing Operations Margin
• Investment bankers consider the income from continuing operations margin to
assess what proportion of revenue the company is able to invest again after
paying all its costs.
• Income from continuing operations margin is calculated as follows:

Income from Continuing Operations Margin = / Total Revenue

• The result of the above formula shows that how much of every dollar the company keeps
from revenue after paying all the costs of operating a business.
Profitability Ratios- Net Margin
• Net income is not a perfect measure as it is created by accountants for
everyone, not for the investment banking professionals.
• Net margin is a valid alternative, which is not so easy to be calculated.
• Net margin can be calculated as follows;

Net Margin =

• Net margin shows that how much of every dollar a company earns after paying
all its expenses.
• It is another proxy of a profitability margin that can vary depending on the
industry the company is in.
Example
Efficiency Ratios
Efficiency ratios show how well a firms’ resources have been used, such as the
amount of profit generated from the available capital used by the company.

The key efficiency ratios for the investment bankers are:

1. Return On Asset (ROA)

2. Return On Capital (ROC)
3. Return On Equity (ROE)
Efficiency Ratio - ROA
• Return On Asset (ROA) measures how effectively a company has used its asset
to generate net profit.
• ROA is measured as follows;
ROA =

• Investment bankers know that the higher ROA, the more efficient a company to
gain profit from the assets it has.
Efficiency Ratio - ROC
• Return On Capital (ROC) is an extremely important financial ratio to investment
bankers.
• It shows the amount of gain from the company investment on its capital (both
debt and equity).
• It quantifies how skilled the management is at investing money – both in debt
and equity – to generate maximum amount of money/return.
• ROC is calculated as follows;

ROC =
Example
Financial 2012 ($ millions) 2011 ($ millions)
Measure

EBIT 1,208.32 Not needed for

calculation

Total equity 1036.75 857.32

Minority interest 11.62 23.63
(debt)

Short-term 118.16 42.08

borrowings
(debt)

Current portion 257.73 97.59

of long-term debt

Long-term debt 1,530.97 1,748.50

Total capital 2,955.24 2,769.12

Efficiency Ratio - ROE
• The Return On Equity (ROE) ratio shows how well management is making use of
the money invested in the business by the shareholders.

• ROE is calculated as follows;

ROE =

Note 1: Evaluating ROE without considering the income from continuing operations is not
possible, which emphasises on the importance of the income from continuing operations.
Company’s Growth Rate
• Investment bankers use the financial statement quite a lot to gather their
required information.
• The criticism of financial statements is that they’re ancient history by the time
they’re released in this world of hyperactive trading.
• Using trends, an investment banker may be able to intelligently speculate in
which direction a company may be headed.
• Growth rate is calculated as follows;

Growth Rate (for a Period) =

Example
Hershey’s Growth Trends:

Financial Measure 2012 ($ millions) 2011 ($ millions) Growth Rate

Revenue $6,644.3 $6,080.8 9.3%

Cost of goods sold $3,784.4 $3,548.9 6.6%

Selling, marketing, and $1,703.8 $1,477.9 15.3%

administrative costs

Interest expense $95.6 $92.2 3.7%

Net income $660.9 $629.0 5.1%

Summary
• Investment bankers use valuation multiples to analyse a company’s value.

• P/E ratio is a common tool.

• EV/EBITDA ratio provide more in depth information about the company’s

performance.

• Investment bankers may use liquidity ratio and efficiency factors to evaluate
the financial status of a company for their analysis and comparison purposes.

• Valuation methods mainly rely on the financial statement information, which

has its pros and cons.