There are two common ways to use comps: precedent transactions and public stocks. Public comps use the current trading price of similar companies. Precedent transactions, or private comps, are recent merger or acquisition prices for similar companies. For either type, it is important to find good comparables and use the correct multiple. Factors like debt load, size, and growth profile can all impact valuation. Additionally, companies in industries that are asset-heavy shouldn’t be valued in the same way as companies that are capital-light and fast-growing.
How Comps Work
The financial data and information services, like Bloomberg or FactSet, that Wall Street professionals use offer up comps in an easily digestible way. You simply type in the ticker symbol of a company and get your valuation. But for individual investors, you don’t need to shell out thousands of dollars for these services in order to do comps. You can find all the info you need from basic financial websites such as Yahoo! Finance or Morningstar. Let’s go over how to do it using Home Depot (HD) as an example. Yahoo’s home page lists five competitors of Home Depot: Lowe’s, Lumber Liquidators, GrowGeneration, Floor & Decor Holdings, and Leslie’s. Let’s gather some basic information about each of the companies and then decide how to do a comps analysis. Before you start your analysis, you already may be leaning toward certain comparables. Most people know that Home Depot and Lowe’s are the two big players in this industry—that is proven true by these comps. Lowe’s and Home Depot both have market capitalizations in the hundreds of billions of dollars and the next closest among the other four is just $13 billion. The four smaller companies also have far higher growth rates and, unsurprisingly, higher P/E multiples (except for LumberLiquidators). At this point, it makes sense to throw out the four smaller competitors. You could use Home Depot’s financial filings, recent news, other research, or even the industry code to find additional competitors if you need to, but the comparable analysis is rarely perfect. Normally, we would apply the average multiple of the comps to Home Depot to calculate a value. In this case, there is only one good comp—Lowe’s—and Home Depot’s multiple of 23.33 is close enough to Lowe’s multiple of 21.02 that the difference is immaterial. Especially because Home Depot has higher margins and growth and less debt. Let’s look at one more example to go through the process using Wells Fargo (WF): Wells Fargo’s price/book multiple is the second-lowest among the five banks. This is because of its profit margin, which is nearly eight percentage points lower than the next-lowest competitor. Wells Fargo’s inferior profit margin should factor into your analysis. If you just looked at the multiples, you would immediately think Wells Fargo was undervalued. By putting the multiple into context, however, you can make a decision based on whether Wells Fargo’s profit margin will be able to rise to the same level as the other big banks on the list. If it does, we can calculate a potential price target by multiplying Wells Fargo’s book value per share of $41.70 by the average multiple of 1.44. Wells Fargo’s reaching $60 per share would mean a gain of 35% from its current price of $44.33.
