Comparables Approach to Equity Valuation Explained

When performing the comparables approach, it's valuable to not only select similar companies in the same sector but to compare performance against industry average. Although our sample size is small in this example, let's compare Eastman Chemical Company to other companies in addition to the average of our sample.

• Market Capitalization: Of the companies selected, Eastman is among the smallest in terms of market cap. This is valuable information when comparing dollar figures like net income, net margin, and free cash flow. This also sets the precedent that Eastman may have less operational efficiencies than Dow Chemical, Dupont, or Air Products & Chemicals.
• Enterprise Value: The enterprise value of Eastman is almost 50% higher than its market cap. The closest comparable is Huntsman, whose enterprise value is roughly 25% higher than its market cap. This indicates that Eastman may have higher debt or lower cash value than the nearest comparable sample.
• Price/Earnings Ratio: Of our sample of 5 companies, Eastman's P/E ratio is fairly similar to the average. This is important to note when comparing other ratios. Because Eastman is among the higher P/E ratios, the market is pricing in expectations that there will be further company growth (at least compared to the companies with lower P/E ratios such as Huntsman or Dow Chemical).
• Price/Revenue Ratio: Unlike the P/E ratio, Eastman is below our sample average for the P/R ratio. This indicates the market expects less revenue growth compared to other firms. By comparison, this means the market is anticipating expense savings or operational efficiencies due to the difference in expectations regarding P/E and P/R.
• Price/Book Ratio: Again, Eastman appears to be on target with our sample average. This is indicates the company's stock is not trading at too high of a premium compared to the industry average.
• Net Margin: As expected, Eastman has yet to capture many economies of scale that the larger companies have been able to capture. It's net margin is the lowest of the group and below the sample average, indicating that this small company is operating on the smallest margins. This indicates that while Eastman has some favorable metrics, it is likely still operating with inefficiencies due to its size.
• Free Cash Flow: The industry average does get skewed by Dow Chemical's large free cash flow (which appears to be a potentially unlikely outlier). Still, it is encouraging to see Eastman's free cash flow similar to (and even larger than) some bigger companies like DuPont and Air Products. This may that Eastman may have cash on hand to invest in its infrastructure for future growth.

Overall, Eastman has a relatively fair price compared to similar industry leaders Its valuation will likely be negatively impacted by its low net margin compared to other companies; however, Eastman has free cash flow to address operational inefficiencies.

Key Considerations for Using the Comparables Approach

It is important to note that it can be difficult to find truly comparable companies and transactions to value an equity. This is the most challenging part of a comparables analysis. For instance, in the example above, only Huntsman Chemical is relatively close in size to Eastman. The other three industry leaders are nearly three times the operational size and likely have the scale and magnitude to operate differently.

Additionally, using trailing and forward multiples can make a big difference in an analysis. If a firm is growing rapidly, a historical valuation will not be overly accurate. What matters most in valuation is making a reasonable estimate of future market multiples. If profits are projected to grow faster than rivals, the value should be higher.

It is also worth noting that different valuation approaches may yield different findings. For example, the discounted cash flow approach looks solely at the company being valued and ignores market factors or competitor data. On the flip side, the stock market can become overvalued at times, which would make a comparable approach less meaningful, especially if comps are overvalued. For this reason, using an aggregate of different approaches often yields the greatest results.

The Bottom Line

Valuation is as much an art as it is a science. The core advantage of the comparables approach is that it involves the easy assessment of a company's valuation versus its peers. However, it's important to use multiple valuation methods to cross-check the findings of any one. In addition, for comprehensive insight, investors should consider broadening the scope of valuations beyond finding value in price ranges to take into account market conditions.