# Stock Valuation Methods Part 3 – Comparable Valuation

## Comparable Valuation:

Using Comparable Valuation (also called Relative valuation) methods allows us to value 1 company using values or ratios from other companies that we average to create 1 common value. To do this we want to use companies as similar as possible to the company we are generating a value for.

To calculate the price of 1 company from other companies we first need to select companies that are as similar to the chosen company as we can. That means

- Similar Industry
- Similar size
- Similar geography
- Similar financial conditions (debt level for example)

It is not reasonable to compare a small technology company for example to Apple given Apples size, reach, marketing power, sourcing power, financial power… we want to try and find similar companies so we can conduct the comparable valuation method.

*Figure 15. Comparable or Relative Valuation Method*

### There are 5 ratios we are using to value the company we are interested in. Lets review those

PE RATIO: (Price to Earnings Ratio) This is a very commonly used ratio that is calculated by taking the price of the stock and dividing by the (most recent generally but can be any time point) 12 months Earnings per share for the company. Earnings per share is calculated as Net Income (Income Statement) divided by fully diluted number of shares of the company.

#### Stock Price / Earnings per Share

PB Ratio: (Price to Book Ratio) This is also a very commonly used ratio that is calculated by taking the price of the stock and dividing by the (most recent generally but can be any time point) 12 months

Book Value of the company. If you recall book value is the value on the financial statements. The Book value for a company is the Common Shareholder’s Equity found on the balance sheet and consists of the

PS RATIO: (Price to Sales Ratio) This is another common ratio that is calculated by taking the price of the stock and dividing by the (most recent generally but can be any time point) 12 months Total Sales per share for the company.

PCF RATIO: (Price to Cash Flow Ratio) This is also a relatively common ratio that is calculated by taking the price of the stock and dividing by the (most recent generally but can be any time point) 12 months cash flow per share for the company. You saw reference to cash flow above in the discounted cash flow section of this book.

EV2EITDA (Enterprise Value to EBITDA) This is also a common ratio used to value companies and is calculated by taking the Enterprise Value of the company (we discussed Enterprise Value above) and dividing it by the EBITDA (Earnings before Interest, Taxes, depreciation and Amortization)

It is worth noting where EBITDA and Net Income are on the Income Statement because they have implications on how we value a company directly with these ratios.

#### Earnings v EBITDA

PE ratio uses net income, or the accounting income remaining after all other costs are paid (salaries, materials, interest, taxes and depreciation)

EV2EBITDA uses EBITDA in the denominator which does not include interest, taxes and depreciation.

If you think about this for a minute, Earnings takes into account the interest payments we make on the debt whereas EBITDA does not.

### So let’s look at a detailed COMPARABLE VALUATION example for Johnson & Johnson (JNJ:NYS)

To calculate the valuation for JNJ we are starting with these ratios above for 5 similar companies:

AbbVie, Bristol-Myers Squibb, Eli Lilly, Merck & Co, Pfizer

To price our company, we use the 5 ratios we have above and calculate the average values for each of those ratios. We then multiply the average ratios by the appropriate measure (earnings per share, sales per share, EBITDA) to generate a value for our company for each of the 5 ratios.

We can then average the 5 calculated values to come up with a comparable value for our company or if the industry warrants, we can use some of the 5 ratios to calculate the value.

In the lower table we show the 5 ratio values for each of these companies along with their average and the values for JNJ on the far left. In the upper left box we show the current per share values for JNJ and in the upper right box the calculated values.

The average PE Ratio for the 5 comparable companies is 28.53 and JNJ’s PE at this time is 20.82. If we take JNJ’s current Earnings per share value of $5.93 and multiple it by the average value of 28.53 we get a relative or comparable PE based valuation of $169.16 for JNJ. We do this over the 5 ratios to get an average and not have 1 value skew the result dramatically. If we have values we think need to be dropped because they are excessively high or low we can do that as well. (Ex: the PB Ratio for ABBV is much higher than the rest and could be removed. Dropping ABBV’s PB ratio reduces the calculation from $224.24 down to $133.27)

(Note: as we mentioned above EBITDA is pre-interest so we need to subtract the debt/share from EV2EBITDA to have it on the same level as the other 4 ratios.)

#### Once this is done we can average the calculated values to get a valuation for JNJ of

(169.16 + 133.27 + 109.96 + 117.08 + 189.23 ) / 5

$143.74

JNJ is trading in the $125 range which implies on a relative basis it is undervalued by 15%.

__Do we buy JNJ based on this calculation?__

Not immediately. What would be helpful first is: Does JNJ always look undervalued compared to this group? We could rerun this calculation for the last 3-5 years to see if this is the trend or we can look at JNJ’s ratios compared to its industry:

On average over the last 10 years JNJ’s ratios have been 95% of the average for the industry it is in.

Based on that, if we reduced the valuation of $143.74 by 5% we still get $136.55 or a 10% undervaluation compared to the industry.

Notes and cautions: This comparable valuation method works well if you have companies that are similar as noted above and also companies that are generating revenue and earnings. Companies that have no revenue are difficult to value using this method as the method is based on revenue or earnings based ratios. In order to do this we would have to make revenue or earnings assumptions for our company.

We have constructed another method for valuing those companies in StockCalc using changes in price over the last 12 months, net PPE and cash and book values.