Part 2 – Lesson 11

Overview


In Part 2, Lesson 9, we looked at the valuation multiples of wireless companies, including Verizon, AT&T, Sprint, and T-Mobile.  We were able to compare the EV/EBITDA, P/FCF, and P/E multiples of these companies because these companies are directly comparable to each other (with one exception).  They all operate in United States, and they all own and operate wireless networks that delivery voice and data signals to consumers.  The only major difference between these peers is the business mix of AT&T.  In recent years, AT&T has made two major acquisitions: DirecTV and Time Warner.  This has increased AT&T’s exposure to the pay television market.  While Verizon has exposure to pay television (Verizon Fios), the exposure is much smaller vs. AT&T.  Despite the exposure to pay TV, AT&T is still predominantly a wireless company, which still allows for useful comparisons to its peers.

However, what should we do when companies are not as comparable?  What factors should we look at to judge the comparability of peers?  Below, we will review a few of these factors:

Business Mix


The single most important factor in judging comparability of peers is the business mix.  Ideally, you want to compare companies that are in the exact same line of business.  However, no two companies are identical.  Large companies tend to have multiple business divisions and may operate in different parts of the value chain.  For example, Walmart and Nike are both “consumer retail” companies, but there are significant differences between these businesses.  Walmart operates large brick and mortar stores that sell everything from clothing to bath products to furniture to groceries.  However, Nike’s scope is much more limited as Nike only sells athletic wear.  Due to the large differences in the type of product that Walmart and Nike sell, most investors would likely hesitate to compare the valuation multiples of these two companies.

Additionally, investors should be mindful of which part of the value chain a company participates in.  For example, Ford and Carmax are both in the auto business.  However, Ford is in the business of designing and manufacturing new vehicles, while Carmax is in the business of selling new and used vehicles.  While these companies are both in the auto sector, many investors would be hard pressed to view these are truly comparable companies.

Customer Exposure


The type of customer a company sells to can also be a factor that reduces comparability when there are large differences in the customer base.  For example, Nordstrom and Ross Stores are both brick and mortar retailers focused on clothing.  However, Nordstrom focuses on very high-end consumers, whereas Ross Stores focuses on value-oriented consumers.  The differences between high-end vs. value-oriented consumers may contribute to differences in the valuation multiple.  This is not a reason to not compare the valuation multiples of these companies at all, but an investor should be mindful of the potential impact to the multiple due to differing customer bases.

Additionally, customer concentration is another key factor that investors should focus on.  Companies with very high customer concentration (greater than 10% of sales for a single customer, for example) generally carry a bit higher risk vs. companies that have diversified revenue bases.  This can also lead to reduced comparability of otherwise similar businesses.

Geographic Exposure


Global companies often operate in multiple geographies.  Additionally, many foreign companies are listed on US exchanges.  Investors should be careful in comparing valuation multiples of companies with significantly different geographic exposure.

For example, Verizon operates solely in the United States.  Vodafone, a European-based telecom provider, operates across Europe, Asia, and Africa.  Although Verizon and Vodafone provide very similar services to their consumers, Vodafone’s geographic exposure to Europe, Asia, and Africa carry a significantly different risk profile than the United States.  Having different geographic exposures is not a reason to avoid comparing valuation multiples of two companies altogether, but investors should again be mindful that the valuation multiples of companies that operate in different geographies may trade at permanent differences in the valuation multiple.

What should we do when companies have significant differences in business mix, customer exposure, and geographic exposure?


Investors compare relative valuation multiples of companies in the same industry to make judgments on whether or not certain companies are inexpensive or expensive.  Depending on the nature of the differences, investors may choose to take certain actions or precautions in their analyses:

  1. Business Mix – If two companies have very little overlap in their business mix, an investor should avoid comparing the valuation multiples altogether. For example, Carmax and Ford are different enough in their business that there are much better comps for each of these companies.  Instead of comparing Ford with Carmax, an investor may want to compare the valuation multiple of Ford to General Motors.In other instances, investors may encounter situations where two companies are similar in one business segment but also own unrelated business segments.  For example, Charter is a pure-play cable operator.  Comcast is also a cable operator, but Comcast made a major acquisition with NBC Universal a few years ago.  NBC is a large enough piece of Comcast’s business that investors need to consider the differences between the business mix of Charter vs. Comcast when comparing the valuation multiples.In Part 2, Lesson 12, we will learn about sum of the parts valuation, which is a helpful tool in analyzing companies with disparate business segments.

  2. Customer Exposure – When two companies show significant differences in the customer exposure, it is important for investors to factor these differences into their assessment of value. For example, let’s assume Company A has revenues that come 100% from 1 customer, whereas Company B has revenues that come 1% from 100 customers.  Other than the customer exposure, Company A and Company B are the same in every other regard.In this example, it is quite likely that Company A is going to trade a discount to Company B.  If Company A hypothetically trades at 8x FCF while Company B trades at 12x FCF, an investor may look at these multiples are draw the conclusion that Company A looks very cheap in comparison to Company B.  However, when factoring in the customer exposure, the 8x FCF multiple is likely justified due to the significantly higher risk that comes with only having 1 customer.  In fact, the 8x FCF multiple may still be too high considering this risk.These differences in customer exposure can lead to permanent differences in valuation between companies.  Investors often refer to this as a “structural difference.”

  3. Geographic Exposure – Similar to customer exposure, investors should factor in geographic differences in their assessment of value. We previously discussed Verizon vs. Vodafone.  Verizon operates in the United States, while Vodafone operates in Europe, Asia, and Africa. Currently, Verizon trades at 6.8x EBITDA, whereas Vodafone trades below 5.0x EBITDA.  Does this mean that Vodafone is undervalued?  Or is this valuation discount warranted?  Due to the lower growth in Europe and higher risk associated with Africa and Asia, it is quite likely that this valuation discount at Vodafone is warranted. Therefore, it would likely be a mistake for an investor to assume Vodafone is undervalued just by comparing it to Verizon’s EBITDA multiple.  Vodafone may be undervalued based on other factors, but an investor should be cautious in drawing that conclusion based on the trading level of Verizon given the differences in geographic exposure between the two companies.