Equity Research: Trading Comparable

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We can use public available data of companies within the same industry to make our trading comparable by using EV multiple like EV/EBIT, EV/EBITDA. We are going to calculate the similar companies' equity value, looking at its diluted shares outstanding as well as options restricted stock units, then understand how to work over the bridge to calculate the EV. Once we got the EV, we want to turn it into EV multiple like EV/EBIT to make comparable analysis. 

EV & EBIT joined together, the higher the EBIT, the higher the EV;

Price & EPS joined together, the higher the EPS, the higher the price:

In terms of multiple, we want to understand what is its value driver and what does it drive? For P/E ratio, the value driver is the denominator, which is the EPS that drives the value - the share price. the value driver should be consistent with value number. Meaning it should stick with EPS, which is driving the value. We can't say the value is driven by the revenue since there are many things are going (interest, cost, tax) on between revenue and the actually earnings that can ba paid to shareholders. For EV/EBIT, it is the EBIT that drives EV. Because the EBIT is operating profit,  and EV is the net operating asset of a business. thus the EV and EBIT go together nicely. 

We aim to establish what multiple of earnings or other important metric similar assets trade at, company A and B probably have the same multiple. If a company A has a P/E of 10x, I then can use that 10x to multiple company B's EPS to get to theorical value, the share price of company B. We want to calculate the value in the same way as well as calculating the value driver, thus work out multiples for a range of different companies within the same industry. Lastly, the valuation is forward looking. So earnings or that value driver should be normalized/cleaned, which mean we want to get rid of any non-recurring items from the past because we need the underlying earnings that are going to continue into the fture.

EV/EBIT is telling you how much do investors are willing to pay in relation to a value driver. It is a very common multiple. Specifically, I should say EV/EBIT can be interpreted as the price that investors are willing to pay for each dollar of a company's operating profit. Same for P/E, it is telling you how much do investors are willing to pay for a comopany's earnings at the end? P/E ratio of a comapny is higer than the average? That means the investors are paying a premium to own that stock. and vice versa. 

Multiples:

EV/EBIT (enterprise multiple) and P/E (equity value multiples) are commonly used multiples.

EV/EBIT: 

  • Can be interpreted as the price that investors(E or D holders) are willing to pay for each dollar of the company's operaing earnings.
  • It is capital structual-neutral, making it ideal for comparing companies with different debt levels.
  • It focuses on operational efficiency without the influence of financing or tax decisions, which is espcially helpful in capital-intensive sector (Manufacturing. oil&gas, Telecom, transportation)
  • It avoids tax distortions, making it a reliable metric for cross-jurisdiction comapany comparisons. 

EV/EBITDA: It is useful because it elimnates the effect of D&A. Microsoft and Google might look similar, but the D&A policy might not the same. One might depreciate its assets in 10 years and another one is in 5 years, thus the D&A expense are different. 

EV/Revenue: 

  • It is useful for industries where the value is driven by the sales revenue like Retail sector.
  • Alternatively, it can be applied to companies that are loss makers. They are not profitable because they are new start-up companies in a new industry where no one is making profit yet.
P/B: Price/Book value.
  • Useful when a company's value is driven by its balance sheet value.
  • Very common in Commodity businesses. Copper, gold, O&G driven businesses where the value of their BS, the assets they hold, drives the value of the business.

Steps for calculating multiples:
  1. Choose comparable companies (Industry focus, company size, growth characterstics cost structure etc.)
  2. Clculate values (EV and equity value.)
  3. Calculate value drivers (If I got my EV, I need an EBIT. So we have to spend time on IS and forward IS. Any forward figures should be clean up.)
  4. Calculate the multiples (Do sense check! make sure there are no outliers like EV/EBITDA of 5000.)
  5. Produce valuation ranges (EV/EBIT imply a share price of X; P/E implied share price of Y; So we want come up with a whole range of valuations to help us narrow down what we think an implied value for this company is.)
Equity Value Calculations:

1. Equity value is calculated by multiplying the traded share price by the number of shares outstanding.

2.
   - Use diluted shares (not basic shares) as they account for future shares from options, convertible debt, etc., reflecting potential dilution.
   - The share price already factors in dilution, so both the price and number of shares should align with this principle.

3. Number of Shares to Use:
   - Use the most recent number of shares (at the period's end), not the average over the period.

4. Share Types to Include:
   - Include all ordinary shares, such as Class A, B, and C shares.
   - Exclude preference shares as they are not part of the company’s ordinary equity.
   - Exclude ADRs (American Depository Receipts) and GDRs (Global Depository Receipts) to avoid double-counting since they represent shares already included.

Further-talk about calculating the Diluted Shares:

1. You need the most recent filling that is telling you the how many basic shares outstanding. For the U.S. companies you can find it on the front page of 10K / 10Q.

2. Include all "could-be" shares to get fully diluted shares outstanding: 
    - Options (don't care the options exercisable/ vested, we use "Outstanding")
    - Restricted Stock Units ( Not "restricted shares"!).
    - Conversion of Bonds (As if converted today, how many shares will be converted?). 

Above for options and RSU, just use Treasury method:
    # of options oustanding x Max (0, (price -strike)/price).
    The strike price is 0 for RSU*






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