WALL STREET PREP CORE MODELING COURSE

Trading
Comparables
Modeling
CASE STUDY: EXTR

v W W W. WA L L S T R E E T P R E P. C O M
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Trading Comparables

Introduction
to Valuation

v W W W. WA L L S T R E E T P R E P. C O M
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Valuation
• If I own a home, I am concerned primarily with the equity value of the home,
or the total value of the home?

• Also, am I concerned with the original price I paid (book value) or what it’s
currently worth (market value)?

• And assuming I’m concerned with what it’s currently worth, do I look to
comparable homes to assess the value (relative valuation), or should I rely on
a cash flow analysis that considers the present value of all the rental income
the property can generate (DCF valuation)?

The same questions apply to the valuation of businesses

• All of these concepts matter, all are interrelated, and depending on your
motivations and perspective, you will focus on some more than on others

• There are various ways to define value, so before getting into the specifics of
Comps valuation, let’s get precise on some definitions

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Equity value vs. Enterprise value
• I decide to start a hot dog business

• Before I can sell hot dogs, I secure financing - $500k with debt
and $450k with equity

Liabilities
Debt $500k
Assets
Cash: $950k
Equity
$450k

I incorporated my company and

arbitrarily issued myself 90k shares.
Since my equity value is $450k, I record
the value of each share as $5.

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Equity value vs. Enterprise value
• I use some of the cash to purchase inventories / equipment

• 20k of the equipment purchased was not paid for with cash;
instead, it was invoiced.

• This put a $20k A/P liability on my B/S

Liabilities
Assets A/P $20k
Cash: $50k Debt $500k
Inventory: $500k
PP&E: $420k
Equity
$450k

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Equity value vs. Enterprise value
• Enterprise value = value of operating assets minus operating
liabilities

• Value of operating assets = all assets except for cash

• Cash is usually treated as a non-operating asset, and is netted

against debt

• Treating cash as a non-operating asset is akin to saying “I can

always use my cash to pay down debt”, so thinking of a net debt
figure is more appropriate than disaggregating debt and cash

• Operating liabilities = all liabilities except for debt

Using the B/S on the prior page, answer the following:

Total assets 970 Enterprise
value
Total liabilities 520 Net debt
Equity value 450 Equity value

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Equity value vs. Enterprise value

Using the B/S on the prior page, answer the following:

Total assets 970 Enterprise 900

value
Total liabilities 520 Net debt 450

Equity value 450 Equity value 450

• Notice that the equation Assets = Liabilities + Equity are simply

being be re-expressed, such that:

• Enterprise value – Net debt = Equity value

• This is a common way to discuss value so make sure you are

comfortable with the basic intuition

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Book value vs. Market value
• So far, we looked at value from the
perspective of the original investment in
the business, or book value (BV)

• Most businesses are worth far more than

Book value vs. market value
the BV on their balance sheets would
• Google has an equity book value of
suggest
$75b per the company’s latest 10-Q
• What tools do we have to determine the • Google shares trade at $875 per share
market value of the business? • With 337m shares outstanding, this
implies an equity market value (market
• For a publicly traded company, the equity cap) of $290 billion
market value is readily observable via the • Google has $50b in cash, $5b in debt
company’s share price x shares per the company’s latest 10Q, implying
outstanding, called market capitalization (market) enterprise value of $290b +
($5b-$50b) = $245b

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Trading Comparables

Introduction to
Trading Comps

v W W W. WA L L S T R E E T P R E P. C O M
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Relative valuation vs. DCF valuation
• While intrinsic valuation (DCF) is derived from the fundamental analysis of the company’s cash
flow generation potential, relative valuation (“comps”) is derived by comparing a company to
its comparable peers.

Most common valuation approaches

Intrinsic Relative

Discounted Trading Transaction

cash flow comps comps

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Why we use trading comps to value companies
• The purpose of a trading comps analysis is to determine what is the “appropriate” value of a
company, based on the market values of operationally similar companies.

• When you try to gauge the fair value of your house by comparing to the values of houses
nearby, you’re doing a comps analysis.

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Comps are analyzed using multiples
• Companies are trickier to value than houses because
finding truly comparable companies is difficult

• Even if you find comparable businesses operationally,

you need to standardize for various factors, most notably
size differences

• Because of the need to account for this difference, we

don’t compare absolute values but rather multiples
(equity/enterprise values are standardized against
various measures of a firm’s profitability)

Some of the most common multiples are

Enterprise value multiples Equity value multiples

Enterprise Value (EV) / EBITDA P/E ratio (Share price / EPS)

EV/ Revenue Market cap / Net income

EV/EBIT P/E to growth (PEG ratio)

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Why we use trading comps to value companies
• In addition to the need to standardize for size differences, other non-operational differences
should be taken into account so as to not distort the comparison

• Financial leverage differences

• Enterprise value numerator is a measure of value independent of leverage

• Revenue, EBITDA, EBIT and unlevered cash flow denominator provide a measure of profit
independent of leverage

• Accounting differences (depreciation method, useful life assumptions)

• Use profit metrics before D&A such as Revenue, EBITDA and unlevered free cash flows

• Useful for companies with comparable levels of capital intensity (otherwise dangerous)

• Temporary distortions (nonrecurring items)

• When using multiples that use historical profits as the denominator, those profits must be
“scrubbed” to exclude distortive one-time items such as restructuring expenses, litigation
costs, and one time gains on sale

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Why we use trading comps to value companies
• Other accounting differences (lease classification, LIFO vs. FIFO)

• Must be treated on industry-specific basis

• May require adjustments to both numerator and denominator

• Business life cycle differences

• Comparable companies operationally may be at different phases of their life cycle (early
stage vs. growth vs. maturity vs. decline)

• Multiples like PEG standardize against different long-term growth rates, while others like
EV/Revenue and EV/EBITDA facilitate comparisons for early stage companies generating
losses

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P/E ratio

Definition Share price / EPS

Equity value / Net income

Description EPS used as proxy for economic equity value

Issues EPS is a measure of accounting profit only during a particular period

Accounting profits can be misleading because they include noncash and
nonrecurring items, and accounting assumptions (such as historical vs. market
costing), and can be manipulated
Also, high PE valuation relative to peers could be justified when high PE firm has
higher growth prospects
Less relevant for high growth companies

Most appropriate for • Mature lifecycle companies

• Companies with positive earnings
• Companies with similar capital structures

Underlying value driver

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PEG ratio

Definition PE ratio / long-term growth rate

Description • Standardizes PE ratios against companies’ expected growth rates (g)

• Higher PEG ratio companies are considered overvalued

Issues • EPS is a measure of accounting profit only during a particular period

• Accounting profits can be misleading because they include noncash and

nonrecurring items, and accounting assumptions (such as historical vs.
market costing), and can be manipulated
Most appropriate for • Companies with positive earnings but at different lifecycle stages
• Meaningless for negative earnings or negative growth
Underlying value driver 1
×
× × 100

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Price to book ratio

Definition 1. Equity value / book value of equity

2. Equity value per share / book value of equity per share
3. Book value is often adjusted to exclude goodwill (“tangible book value”)
Description • Compares market value of equity to book value of equity
• Solves “only one period” problem of PE ratios
• For financial institutions whose equity is marked to market, also solves
some of historical cost problems
Issues • For non-financials, book value usually not an accurate measure of true
equity value because of the historical nature of the balance sheet
• Book value may be negative (large historical losses) making the ratio not
meaningful
Most appropriate for • Banks / manufacturing / other asset-intensive businesses
Underlying value driver

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EV / EBIT

Definition Enterprise value / Earnings before interest & taxes

Description • Isolates core operations without impact of financing decision (interest
expense) and taxes
Issues • Unadjusted EBIT is accounting measure of profitability, which includes
noncash expenses (D&A), nonrecurring items, and differing assumptions
from firm to firm which reduces quality of comparison. These are often
adjusted for comparability.
Most appropriate for • Companies with positive operating income
• Service-based businesses (low capital intensive firms)
• Business with varying levels of capital intensity
Underlying value driver
× 1
×

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EV / EBITDA

Definition Enterprise value/Earnings before interest taxes depreciation & amortization

Description • D&A is a huge noncash expense for capital intensive businesses
• Companies can use different depreciation methods, and useful life
assumptions to equipment so D&A – a noncash accounting expense – can
significantly skew the comparison of operating profitability across two
otherwise identical firms
Issues • Less appropriate for companies with different levels of capital intensity
• Imagine two capital-intensive companies generating the same EBITDA –
the one that requires more capital to achieve it would show a lower
EV/EBITDA multiple making comparison on EV/EBITDA basis less useful
than EV/EBIT
Most appropriate for • Used to value many industries – most popular EV multiple
• Particularly useful for high capital-intensive firms within a particular
industry with similar levels of capital intensity
Underlying value driver &
× 1 ×
×

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EV / Revenue

Definition Enterprise value / Revenue

Description • Useful for early stage, high grow companies, with limited or negative
profitability.
Issues • Presumes peers have comparable cost structure
• As such, this is a multiple of last resort – useful for businesses that are
valued primarily based on future prospects and current operations do not
provide much insight.
Most appropriate for • Businesses with negative EBITDA (High growth, young industries)
• Businesses with similar cost structures (retailers)
Underlying value driver
× 1 ×
×

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Internet & Cable companies

Multiples • EV / monthly subscribers

• EV / website hits (internet only)
Description • Early stage internet businesses with no revenue and negative profitability
can value their business by looking at operating metrics like website hits or
subscribers, under the assumption that they proxy future profitability
evenly across all the companies being compared
Issues • Suffers from the major pitfall that monthly users, subscribers, and website
hits do not necessarily lead to revenues and profits, or will do so at
different rates for different businesses (i.e. a Facebook user does not
convert to profits at the same rate as a Google user)
• Accordingly, use with extreme caution

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Oil & Gas / Energy companies

Multiples • EV / Debt adjusted cash flow (DACF)(1)

• EV / EBITDAX (X stands for exploration expense)
• EV / Unlevered Free Cash Flows
Description • Exploration activities represent one of the largest investments for Oil & Gas
companies
• Companies can choose from two accounting treatments for exploration activities: 1)
Full cost or 2) Successful efforts
• Full cost capitalizes and subsequently depletes, depreciates, and amortizes (DD&A)
all exploration activities
• Alternatively, successful efforts capitalizes only successful exploration activities,
while expensing dry holes
• As a result, different accounting choices can lead to large accounting differences
• EV/DACF and EV/EBITDAX both standardize for these differences by ignoring the
DD&A expense and current exploration investment altogether
• EV / Unlevered free cash flows standardizes for these differences by calculating cash
flows after all exploration activities

1 Debt adjusted cash flows defined as cash from operations plus after tax-interest expense

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Real estate investment trusts (REITs)

Multiples • Share price / FFO per share

• Share price / AFFO per share
Where:
• Funds from operations = Net income + D&A + Gains on Sale
• Adjusted FFO = FFO – Capital expenditures + Nonrecurring Items
Description • Real estate generates a lot of D&A which, especially for land, skews the true picture of
operating profitability.
• Price/FFO and Price/AFFO are levered multiples, so comparisons to similarly levered
REIT’s will be most meaningful

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Trading comps analysis: The process
1. Select comparable companies (peer group)

2. Pick which multiples you will use (EV/EBITDA, P/E)

3. Pick which timeframe you will use

• Last twelve months (LTM)

• Forecast basis (1 year forward or 2 year forward)

4. For each multiple, apply the calculated mean or

median to the target company’s corresponding
operating metrics to arrive at a value.

• Example 1: Multiply the derived average LTM PE

ratio by company’s LTM EPS to arrive at equity value
per share

• Example 2: Multiply the derived median 1 year

forward EV / EBITDA multiple by the company’s 1
year forward EBITDA projection to arrive at
enterprise value

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Comparable Company Analysis Exercise

$ in millions, expect per share data

Company Colgate
Share price $30 / share
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200

Peer group EV/ EV/ P/E

Sales EBITDA
Kimberly Clark 1.0x 6.0x 15.0x
Unilever 2.0 8.0 19.0
Procter & Gamble 1.5 6.5 17.0
Avon Products 1.0 5.8 14.6
Mean 1.4 6.6 16.4

Implied Colgate share price

Is Colgate overvalued based on comps?

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Comparable Company Analysis Exercise

$ in millions, expect per share data

Company Colgate
Share price $30 / share
Shares outstanding 30 million
Revenue $1,000
EBITDA $200
Net income $75
Net debt $200
EV/ EV/ P/E
Sales EBITDA
Peer group mean 1.4x 6.6x 16.4x

Implied Colgate enterprise value $1,400 $1,320 N/A

Less: Colgate net debt 200 200 N/A
Equals: Colgate implied equity value 1,200 1,120 1,230
Colgate shares outstanding (mm) 30 30 30

Implied Colgate share price $40 $37.3 $41

Is Colgate overvalued based on comps? No No No

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“Which is a better way to value a business – DCF or comps?”
• They’re both important. The DCF provides an academically rigorous measure of value, BUT it
is very sensitive to assumptions which makes it easily to manipulate.

• Trading comps tell you how the market is ACTUALLY valuing similar businesses to the one you
are analyzing (i.e. real-world derived value vs. model derived value).

• Another way to think of it is that comps provide a market-based sanity-check to intrinsic

valuation (and vice versa).

• Another difference is implementation – you can’t build a proper DCF without detailed
financials but you only need a few data points (such as EBITDA, sales, net income) to get a
comps-based valuation, so it makes it easier to value private companies or companies with
limited availability of financial information.

• BUT if you were to peel the onion a little (and revisit the underlying value equations for each
multiple outlined earlier in this section), you’d also recognize that applying a peer-derived
multiple to value a business is implicitly making a whole bunch of assumptions about future
cash flows, cost of capital, and returns that you make explicitly when building a DCF so they
are actually very related concepts.

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“What’s the downside to over-reliance on comps?”
• Always comparing apples to oranges. Truly comparable
companies are rare and differences are hard to account for.
Explaining value gaps between the company and its
comparable involves judgment.

• In addition, thinly traded, small capitalization or poorly

followed stocks may not reflect fundamental value. Lastly,
many people feel that the stock market is emotional and that it
sometimes fluctuates irrationally (i.e. the market can be
wrong).

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“If the market is what matters, when valuing a public company, do we even
need a comps analysis? Why not just use the market cap of the company
directly to value it?”
• If the market was perfectly efficient, it stands to reason that it would price individual equities
correctly rendering a comps analysis pointless.

• However, the thinking behind a comps analysis for a public company is that the market may be
efficient on average, but it can be off when pricing individual companies.

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“When using comps to value a public company, should I include the
company in the peer group?”
• Some professionals prefer to exclude the target of the analysis from the peer group because it
will skew the multiple towards the target company’s actual trading values. Despite this, logic
dictates that the target be included (when it is public).

• If the intuition behind a comps analysis is that the market may misprice individual stocks but is
correct on the whole, clearly the target company should be included in its own market-based
valuation.

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“Should I use a median or mean when calculating the comps-derived
multiples”
• For larger peer groups, calculating relevant peer group statistic using median is preferable to
mean calculations because it limits distortions from outliers. For smaller peer groups (less than
5) with no outliers, mean is preferable.

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“Should I place more weight on LTM or forward multiples?”
• That entirely depends on the specifics of the situation. Using historical (LTM) profits is nice
because it represents actual bird-in-hand results, and forecasts for smaller cap companies can
be hard to come by. However, LTM suffers from the problem that markets value companies off
future – not historical – profits and cash flows.

• If LTM results do not include a lot of nonrecurring items and no significant margin and growth
changes are expected over the next 2 years, LTM results can – and should – be used side-by-
side with forward multiples. If these conditions are not met, forward multiples should be relied
on more heavily.

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Conclusion
• Trading comps analysis compares the current trading level of a company to its peers and values
the company based on the valuation multiples of other publicly traded companies with similar
operating and financial statistics

• Trading comps analysis seeks to determine how the market values the earnings, cash flows, net
asset value, assets, or other characteristics of similar companies and compares these ratios
(which vary from industry to industry) to the company’s performance and/or uses them to
impute an aggregate market value of the company

• A useful shorthand for valuation

• The intuition: market is efficient on average, but may be off when pricing individual companies

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Trading Comparables

Preparing to
spread comps
(case study)

v W W W. WA L L S T R E E T P R E P. C O M
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Selecting a peer group
• Key to a good comparable company analysis

• Look for companies that are similar operationally and financially to the target

• Unfortunately, almost always comparing apples and oranges

Selecting a peer group

Similar operational characteristics Similar financial characteristics
Size
Nature of business (industry, products, markets, customers)
Leverage
Industry position
Margins
Seasonality / cyclicality
Growth prospects

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What resources can help determine which companies are comparable?
• Primary resources

• Equity research

• 10-K competition section

• Colleagues familiar with the industry

• Form 8-K related to a merger (within the fairness opinion)

• NAICS /SIC code screens

• News articles/finance websites

• Client (only when applicable)

• Third party services

• Bloomberg terminal (relative value screen)

• Capital IQ

• FactSet

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Results are presented in an output worksheet…

COMPARABLE COMPANY ANALYSIS OUTPUT

Last Twelve Months (LTM) Year 1 Forecast - Calendar Year Year 2 Forecast - Calendar Year
Market
capitalizati Enterprise LT growth
Name Ticker on (mm) value (EV) Revenues EBITDA EBIT EPS Revenues EBITDA EBIT EPS Revenues EBITDA EBIT EPS rate

Extreme Networks, Inc. EXTR 332.2 256.5 324.8 12.5 6.8 0.06 320.6 28.5 22.8 0.23 337.5 37.7 30.4 0.30 14.0%
Brocade Communi. BRCD 2,200.8 2,328.4 2,157.4 409.8 210.1 0.20 2,211.0 607.1 413.0 0.60 2,288.0 611.6 412.0 0.55 8.0%
Juniper Networks JNPR 8,329.7 5,898.7 4,379.6 661.5 488.8 0.58 4,409.7 861.8 687.8 0.87 4,899.3 1,129.0 955.0 1.21 15.0%
Netgear NTGR 1,276.7 907.2 1,227.8 145.2 130.5 2.49 1,362.4 167.9 164.1 2.89 1,557.2 190.2 180.8 3.10 20.0%

Last Twelve Months (LTM) Year 1 Forecast - Calendar Year Year 2 Forecast - Calendar Year
EV / EV / EV / EV / EV / EV /
Name Ticker Revenues EBITDA EV / EBIT P/E Revenues EBITDA EV / EBIT P/E Revenues EBITDA EV / EBIT P/E PEG ratio

Extreme Networks, Inc. EXTR 0.8x 20.6x 37.9x 54.0x 0.8x 9.0x 11.2x 15.2x 0.8x 6.8x 8.4x 11.7x 1.1x
Brocade Communi. BRCD 1.1x 5.7x 11.1x 24.2x 1.1x 3.8x 5.6x 8.2x 1.0x 3.8x 5.7x 8.9x 1.0x
Juniper Networks JNPR 1.3x 8.9x 12.1x 26.9x 1.3x 6.8x 8.6x 17.9x 1.2x 5.2x 6.2x 12.9x 1.2x
Netgear NTGR 0.7x 6.2x 7.0x 13.2x 0.7x 5.4x 5.5x 11.4x 0.6x 4.8x 5.0x 10.6x 0.6x

High 1.3x 20.6x 37.9x 54.0x 1.3x 9.0x 11.2x 17.9x 1.2x 6.8x 8.4x 12.9x 1.2x
Low 0.7x 5.7x 7.0x 13.2x 0.7x 3.8x 5.5x 8.2x 0.6x 3.8x 5.0x 8.9x 0.6x
Median 0.9x 7.6x 11.6x 25.5x 0.9x 6.1x 7.1x 13.3x 0.9x 5.0x 5.9x 11.1x 1.1x
Mean 1.0x 10.4x 17.0x 29.6x 1.0x 6.3x 7.7x 13.2x 0.9x 5.2x 6.3x 11.0x 1.0x
EXTR 0.8x 20.6x 37.9x 54.0x 0.8x 9.0x 11.2x 15.2x 0.8x 6.8x 8.4x 11.7x 1.1x

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…and represent one component in a suite of valuation methodologies. In
investment banking, these are presented to client in pitches, live deals
(mandates), and fairness opinions.

$24.5
$24.0
$23.0

$22.0
$21.0

$20.0
$19.0 $19.0

$18.0

$17.0 $16.0
$16.0 $16.5

$15.0
$14.0

$13.0
$12.0

$11.0 $11.0
$10.0
DCF 4% Terminal DCF 5x EBITDA LBO Trading Comps Transaction Comps 52 Week H/L
Growth Exit Multiple

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Case study: Extreme Networks (NASDAQ: EXTR)
• Founded in 1996 in California, Extreme is a provider of
network infrastructure equipment (primarily Ethernet
switches) and services for enterprises, data centers, and
service providers.

• Extreme sells via distributors, resellers, system integrators, Extreme Ethernet switch

strategic partners, and directly to certain accounts. What is an Ethernet

switch?
• End-customers are businesses, hospitals, schools, hotels, A device used to connect
multiples computers,
telecommunications companies and government agencies.
servers, laptops, printers,
or other Ethernet
• Fiscal 2013 year end revenue was $300m, with $10 in net
enabled devices to a
income. Local Area Network
(LAN). Switches are
often incorporated into
routers

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The process of building comps

Step 1: Pick Step 2: Calculate Step 3: Present

comps multiples results
• CIQ / FacstSet / • Input market data • Analyze output of
Bloomberg • Input options data comps analysis
• SIC/NAICS Code • Input LTM data
Screens • Input balance sheet
• Equity research data
• SEC filings • Input projection data
• Colleagues

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Picking comps
• Without industry expertise, this is usually a process of triangulation.

• Target company filings

• A good place to start is with the company’s 10-K competition and MD&A sections but a full
list likely isn’t going to be there.

• Sell-side equity research

• Determine the analysts covering the target company and check their coverage universe

• Third party services

• Bloomberg, Capital IQ, and FactSet make it easy to screen by SIC and NAICS codes

• These services also curate comp sets but can be hit or miss

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Using company filings to screen for comps
2013 10-K
Item 1: Business

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Using sell-side research to screen for comps

Wedbush’s Extreme Networks analyst coverage (1)

1 Source: Capital IQ

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Case study: Extreme Networks Comps Set

Comp Comments
Aruba Aruba Networks, Inc. provides network access solutions for the mobile enterprises worldwide.
Networks • Same industry, seemingly similar products, covered by research analyst covering EXTR
ARUN • Not identified by EXTR as competitor and vice versa
• Bigger than EXTR
Brocade Brocade Communications Systems, Inc. engages in the supply of Internet protocol based
Comm. Ethernet networking solutions and storage area networking (SAN) solutions to businesses and
Systems organizations worldwide.
BRCD • Same industry, seemingly similar products, covered by research analyst covering EXTR
• Identified by EXTR as competitor and vice versa
• Bigger than EXTR
Juniper Juniper Networks, Inc. designs, develops, and sells products and services that provide network
Networks infrastructure for networking requirements of service providers, enterprises, governments, and
JNPR research and public sector organizations worldwide.
• Same industry, seemingly similar products, covered by research analyst covering EXTR
• Identified by EXTR as competitor and vice versa
• Bigger than EXTR
Cisco Cisco Systems, Inc. designs, manufactures, and sells Internet protocol (IP) based networking
Systems and other products related to the communications and information technology industries
CSCO worldwide.
• Same industry, broader offering, covered by research analyst covering EXTR
• Identified by EXTR as competitor
• Much bigger than EXTR – too big?

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Case study: Extreme Networks Comps Set

Comp Comments
F5 F5 Networks, Inc. provides application delivery networking technology that secures and
Networks optimizes the delivery of network-based applications, and the security, performance, and
FFIV availability of servers and other network resources.
• Same industry, different products, covered by research analyst covering EXTR
• Not identified by EXTR as competitor
• Much bigger than EXTR
Netgear NETGEAR, Inc. provides networking products to consumers, businesses, and service providers.
NTGR Its Retail business unit offers home networking, storage, and digital media products to connect
users with the Internet, and their content and devices.
• Same industry, EXTR reseller, covered by research analyst covering EXTR
• Not identified by EXTR as competitor
Radware Radware Ltd. develops, manufactures, and markets integrated application delivery and network
RDWR security solutions worldwide.
• Same industry, covered by research analyst covering EXTR
• Not identified by EXTR as competitor
• Smaller company like EXTR (but still bigger)
ShoreTel ShoreTel, Inc., together with its subsidiaries, engages in the development and sale of Internet
SHOR protocol (IP) communications systems for enterprises in the United States and internationally.
• Same industry, covered by research analyst covering EXTR
• Seemingly similar products but not identified by EXTR as competitor
• Only company in comp set of similar size to EXTR

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Case study: Extreme Networks Comps Set

Comp Comments
Plantronics Plantronics, Inc., together with its subsidiaries, engages in the design, manufacture, and
PLT marketing of communications headsets, telephone headset systems, and accessories for the
business and consumer markets under the Plantronics brand worldwide.
• Same industry, EXTR reseller, covered by research analyst covering EXTR
• Not identified by EXTR as competitor, consumer driven products might be too different from
EXTR’s business
• Bigger than EXTR
Polycom Polycom, Inc. provides standards-based unified communications and collaboration (UC&C)
PLCM solutions for voice and video collaboration.
• Same industry, EXTR reseller, covered by research analyst covering EXTR
• Not identified by EXTR as competitor, products might be too different from EXTR’s business
• Bigger than EXTR
Riverbed Riverbed Technology, Inc. provides solutions to the fundamental problems associated with
RVBD information technology (IT) performance across wide area networks (WANs) in the United States
and internationally.
• Same industry, EXTR reseller, covered by research analyst covering EXTR
• Not identified by EXTR as competitor, products might be too different from EXTR’s business
• Bigger than EXTR

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s Model
lowing modeling steps cover:

ding the EXTR comp

Open the following files to begin:

• Comparable Company Template EMP
• EXTR 2013 10K.pdf
• EXTR Q4 2013 PR.pdf
• EXTR Q2 2014 10Q.pdf
• EXTR Q2 2014 PR.pdf
• EXTR 2.pdf (Factset IS estimates)
• EXTR 3.pdf (Factset EPS estimates)

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This is what we are working towards…
Input tab
• Contains the raw data for each comp
• Each comp is organized vertically

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This is what we are working towards…
Output tab
• Contains the output data
• Enables us to easily compare key
multiples and financial statistics

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This is what we are working towards…
Valuation matrix
• Shows us the implied target share
price based on the comp set

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This is what we are working towards…
Football field
• A graphical representation of the
valuation matrix

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Getting the raw data
• Latest 10-K and corresponding Q4 10-Ks and 10-Qs
• To find the latest filings, go to company website (investor
press release relations), sec.gov, or data services like CIQ/FS.
Press release & conference call transcripts
• If latest quarter is anything other • Released up to several weeks prior to filing 10-Qs and 10-Ks
than the 4th quarter, you’ll also • Less general detail than the 10-Qs and 10-Ks, but contain
need the latest 10-Q and more non-GAAP disclosures critical for analysts
• If you ignore the PR, you may be ignoring an entire quarter of
corresponding press release available results!
Equity research reports & EPS consensus estimates
• Latest equity research & EPS • Available via Thomson, FactSet, and CIQ
consensus estimates • Reports are almost always published within several days
following a company’s latest quarter press release.
• Last 12 months news run:

• Look specifically for stock splits, major acquisitions & other material changes

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Gather appropriate filings and press release for EXTR and complete cells C8:C9
Input the latest fiscal year and reported quarter as of 4/28/14

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Trading Comparables

Shares outstanding

v W W W. WA L L S T R E E T P R E P. C O M
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Diluted vs. basic shares outstanding
• You should use diluted shares instead of
The observed price for a slice of pizza
actual (basic) shares when calculating market
depends on the size of the slice…
capitalization.
$4 $2
• This is because the market share price
accounts for not just the actual shares
outstanding, but also potentially dilutive
securities.

• Ignoring this in the share count would

understate the market cap of the business
Entire pie = $16 Entire pie = $16

…and if you want to calculate the price

of the entire pie, you’d better
understand exactly how many slices are
in the pie.

If you get the number of slices wrong,

you’ll get the price for the entire pie
wrong.

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Diluted shares outstanding
• Market cap = share price x diluted shares outstanding:

• Diluted shares = Actual share count (basic shares) + dilutive securities(shares that aren’t quite
common stock yet but can become common stock)

Dilutive securities:

• Stock options are issued to pay and motivate employees. Gives employees the option to
purchase common stock at a given price over an extended period of time

• Warrants are similar to options. They are certificates entitling the holder to acquire shares of
stock at a certain price within a stated period. When warrants are exercised, the holder must
pay a certain amount of money to obtain the shares. Also, when stock warrants are attached to
debt, the debt remains after the warrants are exercised

• Convertible bonds are bonds that the company issues that can be converted into common
shares upon a certain strike price. The conversion feature allows the corporation an
opportunity to obtain equity capital without giving up more ownership control than necessary
and/or entice investors to accept lower interest rates than they would normally accept on a
straight debt issue

• Convertible preferred is similar to convertible debt, except that it is preferred stock

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Calculating shares outstanding
A business with an equity value of $500m has 100m shares outstanding

• What would you expect this company’s share price would be? ___________________________

Now assume optionholders hold 25m exercisable options (assume a $0 exercise price)

• What would you expect this company’s share price would be? ___________________________

Now assume that in addition to the options, convertible preferred shareholders hold 15m shares,
each convertible into 5 shares of common stock (assume no dividends and no liquidation value).

• What would you expect this company’s share price would be? ___________________________

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Basic shares outstanding
• You can find the latest outstanding
number of common shares
outstanding by looking at the front
page of the latest filing (i.e., 10-Q or
10-K)

92,989,772

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Options
• Typically, you find options information in the 10-K, NOT in the 10-Q
Finding the
• For trading comps, use exercisable options. options
footnote
Search for the
terms
“exercisable”,
“options
outstanding”,
or “granted” to
quickly find
the footnote in
a long 10-K

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Options
• A tranche of options is a class of options with the same weighted average strike price.

• We evaluate options on a tranche-by-tranche basis to see if they are “in the money.”

• Each tranche has an exercise (strike) price, which the owner must pay to exercise the option

• “In-the-money” options are options in which the strike price < current stock price

• “At-the-money” options are options in which the strike price = current stock price

• “Out-of-the-money” options are options in which the strike price > current stock price

• We only include “in the money” options in the share count because these are the options that
have potential to dilute the company’s shareholder base.

Options
tranches

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Calculating options using the treasury stock method (TSM)
• An approach to calculating diluted shares that assumes that proceeds from exercised options
and warrants are used to repurchase outstanding shares at the current share price.

• Minimizes dilutive impact of option conversion on existing shareholders.

• Most common approach in practice

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Stock splits
• When companies announce stock splits, all share count and dilutive securities counts prior to
split must be adjusted to reflect the split.

• Otherwise, the market share price will reflect a post-split price while the share count will be
pre-split, leading to a huge underestimation of market cap

• To avoid this, always confirm that no split has taken place subsequent to the latest financial
report.

• If you have access to a Bloomberg terminal, the easiest way to check is to select ‘CACS’ on the
Bloomberg terminal to review recent corporate actions.

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Dual classes
• Sometimes companies issue 2 or
more classes of common stock (A
and B), where one class has more
voting rights.

• The rationale is to allow

management, families, and other
insiders to retain voting control
without a 1-for-1 stake in equity.

• Count both classes equally in the

share base and include a footnote.

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Dealing with convertible preferred stock in comps
• If the company has convertible preferred stock on its balance sheet, analysts must determine
whether to assume conversion for the purposes of calculating diluted shares outstanding

• If conversion is assumed, exclude the preferred stock from the balance sheet and any preferred
dividends from the cash flow statement.

• To determine whether the preferred stock should be assumed converted, employ 2 tests:

• Test 1: Are the convertibles in the money or out of the money?

• If in-the-money, proceed to test 2

• Test 2: Is assuming conversion dilutive or anti-dilutive

• If dilutive, assume conversion for purposes of calculating shares

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Test 1: In the money?
• If the market share price is > conversion price, the convertible preferred stock is in the money.

Liquidation (redemption value) of preferred shares

Conversion price =
Conversion ratio × preferred shares outstanding

• Liquidation value represents that value that the firm must pay to eliminate the obligation in
the event of liquidation or sale, and is proxied by the book value of the preferred stock on the
balance sheet.

• The conversion ratio represents the number of common shares that each convertible share
can receive upon conversion

• Preferred shares outstanding represent the number of preferred convertible shares currently
outstanding (do not confuse this with shares authorized which are typically much bigger).

• The conversion price represents the value of each common share held by preferreds post-
conversion given the liquidation (book) value.

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Test 2: Dilutive or antidilutive
• Companies with preferred stock usually issue preferred dividends.

• When assuming conversion, we must reflect that preferreds will no longer receive dividends.

• If the dividend is sufficiently high, its elimination due to conversion will actually be
antidilutive. In this case, we assume that preferred shareholders will not opt to convert (logic
being they are getting a larger fraction of profits as preferred rather than as common – see
exercise below).

Scenario 1 Scenario 2 Scenario 3

Net income 100.0 100.0 100.0
Preferred dividends 15.0 10.0 20.0
Net income to common 85.0 90.0 80.0
Basic shares 170.0 170.0 170.0
Basic EPS $0.500 $0.529 $0.471
Pref. stock dividend yield 15.0% 10.0% 20.0%

Diluted net income $100.00 $100.00 $100.00

Dilutive impact of converted shares 30.0 30.0 30.0
Diluted EPS $0.500 $0.500 $0.500
As-converted pref. shares as % of total 15.0% 15.0% 15.0%
Dilutive or antidilultive?

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Real world exercise: Colgate’s convertible preferred stock
• Information about convertible securities can usually be found on the balance sheet and in the
footnotes of a company’s 10-K and 10-Q’s.

Exercise: Testing Colgate’s convertible preferred stock in 2010

Using the disclosures on the next two slides and the assumptions
below answer the following:
Does Colgate’s convertible preferred stock meet conversion tests in 2010?
Assumptions
In 2010, Colgate had:
• 2,405,192 convertible preferred shares outstanding
• 487,800,000 weighted average basic shares outstanding
• CL share price as of time of the analysis of $66.84
• Calculate Basic & Diluted EPS using the information provided here and in the disclosures
in the next two slides, do not use the company’s reported EPS.

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Real world exercise: Colgate’s convertible preferred stock

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Real world exercise: Colgate’s convertible preferred stock

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Real world exercise: Colgate’s convertible preferred stock
• Information about convertible securities can usually be found on the balance sheet and in the
footnotes of a company’s 10-K and 10-Q’s.

Exercise: Testing Colgate’s convertible preferred stock in 2010

Test 1
• Conversion price = $65 redemption value per share / 8:1 conversion ratio = $8.13
• Conversion price ($8.13) < Share price ($66.84)

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Real world exercise: Colgate’s convertible preferred stock

Test 2
Preferred shares 2,405,192.0
Preferred dividends/share 16.24

Net income 2,203,000,000 This is pre-preferred dividends

Preferred dividends 39,060,318
Net income to common 2,163,939,682

Basic shares 487,800,000

Basic EPS $4.44
Pref. stock dividend yield 1.8% Pref. dividends / Net income

Diluted net income 2,203,000,000 Net income assuming preferred convert

Dilutive impact of converted shares 19,241,536
Diluted EPS $4.34
As-converted pref. shares as % of Common shares held by preferreds / total dilutive
total 3.8% shares
Dilutive or antidilultive? Dilutive

Does Colgate’s convertible preferred stock meet conversion tests in 2010?

Yes

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Convertible debt
• Same mechanics as preferred stock

• Convertible debt is converted to common shares as follows:

Book value of convertible debt
• Conversion price =

• The same 2 conversion tests are employed with convertible debt.

• In the money? As long as conversion price is below market price, test 1 is passed.

• Dilutive or antidilutive? Companies typically pay interest on convertible debt. If we are

assuming convertible debt is being converted to common shares, we must assume that
convertible holders will no longer receive this interest. If the interest is sufficiently high,
such that elimination due to conversion will actually be antidilutive, we cannot assume that
debtholders will opt to convert. As such, a dilution test is employed as the second criteria for
determining conversion.

• Remember that if we assume conversion, exclude convertible debt from the balance sheet and
any associated interest expense from the income statement.

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Restricted stock
• Similar to options, restricted stock is another way to provide employees stock based
compensation.

• Restricted stock are shares (or the right to shares) subject to vesting and, often, other
restrictions. Unlike options, there is no exercise price and employees receive the stock free and
clear after vesting.

Treatment of restricted stock in the calculation of diluted shares

• Vested restricted shares: Like options, restricted stock vests over several years, but when they
vest, they automatically get included in the actual share count, so there is no dilutive impact

• Unvested shares: Similarly to unvested options, unvested restricted shares are typically not
included in the diluted share count.

• An alternative approach (rarely used but more conceptually rigorous) is to apply an

illiquidity discount to unvested restricted shares and to include this in the diluted share
count.

• Completely ignoring unvested restricted stock leads to an underestimation of market cap

and enterprise value.

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Restricted stock

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Trading Comparables

Inputting historicals

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Calculate EXTR latest diluted shares outstanding
• Latest basic shares outstanding can be found on front cover of latest 10Q
• Locate and input EXTR’s tranche by tranche options data in their 10K
• In line with common practice (for better or worse) we ignore restricted shares
• Determine if EXTR has any convertible securities that should be considered

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 9 Check your work
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Input IS and CFS data from the 10K
• Because comps look at EV/Rev, EV/EBITDA, EV/EBIT and PE multiples on an LTM basis, we need to input
LTM Revenue, EBITDA, EBIT and EPS data
• We’ll start with the latest full year (10K), add the latest “stub period” (the last 6 months results) and then
subtract the prior years first 6 months to arrive at LTM.

Find the IS and CFS in the 10K and

input the data…

Leave Non-GAAP exclusions blank

for now: We’ll get to this next

Input D&A data from the cash flow statement

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 9 Check your work
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Open Factset’s EPS estimates doc (EXTR3.pdf) and locate the 2013 EPS
• We have the GAAP EPS but the “primary” EPS Factset provides is $0.17
• This is because analysts covering EXTR are usually more interested in the Non-GAAP EPS ex. SOE
• What’s that? And should our comps sets calculate PE multiples using this EPS instead?

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Find all Non-GAAP items in EXTR’s Q4 PR
• Input them into the appropriate categories in the
non-GAAP exclusions section
• Your EPS should now be $0.17 – not $0.10

See Appendix: GAAP vs. Non-GAAP

for more detail

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 9 Check your work
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Input GAAP data for the first six months of FY 2014 and 2013 using the FY2014 Q2 10Q
• Recall that we just inputted the latest full year (10K) but we still need to add the latest “stub period” (the last
6 months results) and then subtract the prior years first 6 months to arrive at LTM.

Don’t make non-GAAP adjustments yet!

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 Sanity check: Make
sure the calculated
EPS in your model tie
to the 10Q

9 Check your work

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Input non-GAAP exclusions for the first six months of both FY 2014 and 2013 using the FY2014 Q2 PR

Take note!
• A portion of amortization is
being excluded from non-
GAAP operating income
(EBIT)
• This means that we need to
revisit the D&A we added
back to EBIT to get to
EBITDA
• In addition, notice that the
shares used in calculating
non-GAAP diluted EPS is
slightly different from the
diluted shares disclosed in
the GAAP based 10Q

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Trading Comparables

Net debt

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Net debt
• Since in addition to equity multiples (P/E), which require that we calculate equity value, we
will also be calculating EV/EBITDA and EV/Sales multiples, which require that we calculate
enterprise value.

• Since Enterprise value = Equity value + Net debt, we need to calculate net debt:

Components of net debt

• Gross debt

• Debt

• Non-controlling interests

• Preferred Stock

• Cash and equivalents

• Cash and equivalents

• Marketable securities and investments

• Other non operating assets

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More on gross debt
• Notes payable

• May be identified separately or lumped in with current portion of long-term debt. If it is

lumped together, the Debt footnote will identify them separately.

• Current portion of long-term debt

• Portion of debt with an overall maturity of more than a year due within 12 months.

• May be identified separately or lumped in with Notes Payable. If it is lumped together, the
Debt footnote will identify them separately.

• Capital leases1

• Typically treated as debt equivalents

1 For lease-intensive industries, off-balance sheet operating leases are also capitalized and included in comps as debt equivalents

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Long-term debt (including convertible debt)
• The company’s borrowings with a maturity (full repayment) exceeding 12 months

• Debt is identified by tranche in the debt footnote, along with interest rates and dates of
maturity

• Additionally, the footnote will disclose the projected aggregate maturities of long-term debt

• When debt is convertible, footnote will often disclose the number of shares the debt is
convertible into, in addition to the conversion price

Noncontrolling interests
• Portion of the consolidated business that the common shareholders do not own

Preferred stock (including convertible preferred stock)

• Non-common equity financial claim on the business with priority over common stock

• For convertible stock, footnote will often disclose the conversion features

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Input net debt balances from the latest 10Q

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Now that we have all the data need to calculating LTM multiples – we turn to forward multiples
• We have included forecasts from Factset (CIQ and Thomson are also go-tos depending on your firm)

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Fill in the forecast data

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Trading Comparables

Finishing touches

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Calendarization
• A comps analysis involves comparing multiples for multiple companies

• However, a problem emerges when the companies all have different fiscal years because in
order to compare multiples standardized against some operating metric (like revenue, EBITDA,
EBIT, or net income/EPS), they all have to be of the same timeframe.

• As a result, an adjustment is made to all companies to adjust their operating results to a

December 31 calendar year end.

Example:
• Current date June 25, 2013 EXTR 2013 FY June 30, 2013 EXTR 2014 FY June 30, 2014
EPS Estimate: $0.16 EPS Estimate: $0.27
• EXTR FYE – June 30

• EXTR consensus EPS for FYE Jun. 2013 is $0.16

Calendar Year 2013 Dec 31, 2013
• EXTR consensus EPS for FYE Jun. 2014 is $0.27 EXTR EPS Estimate: $0.22

• EXTR EPS adjusted to December 31, 2013:

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Review the calendarization section

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Review the multiples section – the EXTR comp is now complete

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Spread the following comps alongside EXTR

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Trading Comparables

Appendix: GAAP
vs. Non GAAP

v W W W. WA L L S T R E E T P R E P. C O M
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GAAP vs. Non-GAAP
• Companies must present financial statements (balance sheet, income statement, cash flow
statement, and statement of shareholders’ equity) in accordance with Generally Accepted
Accounting Principles (GAAP).

• GAAP reflects an attempt to present information in a useful way to the investing public but
there are many grey areas where there are disagreements about the optimal way to present
something.

• Some common grey areas where GAAP’s accounting treatment differs from the prevailing
analyst treatment include:

• Stock-based compensation expense (SBC)

• Amortization expense

• Nonrecurring items

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Stock-based compensation expense (SBC)
• Most companies that issue stock options to employees, issue them at-the-money and with
vesting periods, meaning employees are unable to immediately derive value from options.

• However, they clearly have some value, and under GAAP companies are required to estimate
this value and recognize it as a compensation expense as the options are issued just like
regular wages.

• Companies can use a variety of options pricing models to estimate this value.

• But unlike salary, the company doesn’t have to issue cash immediately, or even stock
immediately.

• The expense recognized on the I/S is a noncash expense like depreciation.

• Despite the GAAP requirement, most analysts and investors covering industries where there is a
lot of SBC ignore the expense and adjust reported earnings to exclude the expense.

• Since SBC expense reduces GAAP tax expense, when analysts ignore SBC expense, they should
also ignore the reduction to GAAP tax expense due to the SBC.

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Stock-based compensation expense (SBC)
• Like D&A, SBC is not explicitly identified on the I/S, but because it is a non-cash item, it is
added back to net income to get to CFO on the CFS.

• For Apple, like many companies that issue significant amounts of stock as part of employee
compensation, this line item can be a significant non-cash component of expenses.

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Amortization
• This non-cash expense is sometimes (but not always) ignored by analysts when analyzing
earnings, meaning reported GAAP-based results are adjusted by analysts to exclude the impact
of this amortization. When amortization is ignored, EPS is called “Cash EPS”.

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Nonrecurring items
• Three broad types of activities are presented separately from the rest of the income statement.

• Discontinued operations: When a company discontinues or sells off a distinct part of its
business, the income and expenses from this part of the business, as well as severance,
facility closure expenses, etc. will be recognized below net income in a separate category.

• Extraordinary items: Things like losses from the expropriation of assets.

• Accounting changes: If a company changes its accounting method for depreciation or

inventory accounting (LIFO vs. FIFO), the corresponding depreciation or cost of goods
expenses will change.

• For the above activities, FASB and analysts are generally in agreement – report them net of
taxes as a separate line below net income so it doesn’t muddy the waters of ongoing
profitability.

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Nonrecurring items
• Walmart reported income and loss from discontinued operations in the last 3 years.

• It is reported clearly as an aggregate net income/expense line below ‘income from continuing
operations’:

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Nonrecurring items: Unusual or infrequent items
• However, there are certain income and expenses that FASB feels should not be excluded from
earnings and therefore require companies to embed within the income statement, but that
analysts do frequently want to remove from the I/S results to hone in on core operating
profitability. These items include:

• Restructuring expenses

• One-time write offs

• Gains/losses on sale of assets

• Severance costs

• Litigation gains/losses

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Nonrecurring items: Unusual or infrequent items
• Walmart disclosed $260 million restructuring expenses in their footnotes.

• US GAAP does not allow this to be reported below net income; this expense was embedded
within SG&A:

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Tax issues with unusual or infrequent (nonrecurring) items
• Can be presented pre-tax or after-tax

• When presented pre-tax, eliminating taxable nonrecurring items should be accompanied by

the elimination of their tax impact

• Think of it this way – eliminating nonrecurring items is like pretending they didn’t occur

• Extending this logic, if a nonrecurring expense (income) is ignored, so should the associated
tax shield (expense)

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GAAP vs. Non-GAAP presentation
• The adjustments discussed so far: SBC, other non-cash items, and nonrecurring items are so
common for some industries that companies increasingly align their presentations and
disclosures to facilitate the analysis.

• While companies are not allowed to deviate from GAAP-basis presentation in the core financial
statements, they can provide additional NON-GAAP schedules and provide NON-GAAP future
guidance.

• In fact, management guidance is typically presented on a non-GAAP basis, with guidance for
expenses and EPS excluding SBC and unusual or infrequent items.

• In parallel, analyst consensus EPS estimates are usually communicated on a non-GAAP basis.

• Industries often have their own additional and unique non-GAAP conventions.

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GAAP vs. Non-GAAP presentation
• There is no uniform presentation of these items on the income statement.

• Press releases (PR) and conference call transcripts are the most common places – management
often provides analyst-friendly presentations and disclosures in the PR and conference call.

• In the 10K and 10Q, they are often aggregated within major expense categories like COGS,
SG&A, operating expenses and will be disclosed in the footnotes.

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GAAP vs. Non-GAAP presentation

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GAAP vs. Non-GAAP presentation

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Exercise
• Below is a historical and projected I/S . You are also provided with the following information:

• 2011 COGS Includes a $14 inventory write-down

• 2012 COGS includes a $18 inventory write-down

• 2012 SG&A includes a $12 litigation gain

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Exercise
• Using the disclosures on the prior page, create a normalized I/S (including both historicals and
forecasts) that reflect the elimination of nonrecurring items

• Assume write downs were tax deductible and litigation gain was taxable, at a 35% tax rate

• Was it in management’s interest to disclose the nonrecurring items?

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Solution

• It was in management’s interest to identify the nonrecurring items, as their elimination shows
improved margins and profitability. Since forecasts in this model are driven off historical
ratios, the operating forecasts improve when eliminating historical nonrecurring items.

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GAAP to non-GAAP exercise
• The following GAAP-based I/S was prepared by Lemonade Stand Enterprises (LSE).

• In addition, LSE provided the following non-GAAP disclosures:

Jan. 1 –
$ in thousands, except per share data Dec. 31, Pre-tax stock-based compensation
2015

Revenue
$7m in COGS; $2m in SG&A
240.0
Cost of Goods Sold
Other items
68.0
SG&A
1. $4m in pre-tax restructuring expenses
23.4
in COGS; $1m in SG&A
Operating income (EBIT) 148.6
2. $12m pre-tax loss on sale in non-
Interest expense, net 2.0 operating income / (expenses)
Non-operating income / (expenses) (10.0) 3. $2m pre-tax litigation gain in non-
Pretax income 136.6 operating income / (expenses)
Less: Tax expense 54.6
Net income 82.0 Please convert the GAAP I/S to a non-
Basic shares (weighted avg.) 8,500.0 GAAP I/S
EPS 9.642
Tax rate 40%
EBITDA 161.0

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GAAP to non-GAAP exercise

Jan. 1 –
$ in thousands, except per share data Dec. 31,
2015

Revenue 240.0
Cost of Goods Sold Pre-tax stock based compensation
SG&A $7m in COGS; $2m in SG&A
Operating income (EBIT) Other items
Interest expense, net 1. $4m in pre-tax restructuring expenses
Non-operating income / (expenses) in COGS; $1m in SG&A
Pretax income 2. $12m pre-tax loss on sale in non-
operating income / (expenses)
Less: Tax expense
3. $2m pre-tax litigation gain in non-
Net income operating income / (expenses)
Basic shares (weighted avg.) 8,500.0
EPS
Tax rate 40%
EBITDA

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