Business Profile

Companies that share core business characteristics tend to serve as good comparables. These core traits include sector, products and services, customers and end markets, distribution channels, and geography.

10-K (Annual Report)

The 10-K is an annual report filed with the SEC by a public registrant that provides a comprehensive overview of the company and its prior year performance.¹⁷ It is required to contain an exhaustive list of disclosure items including, but not limited to, a detailed business description, management's discussion & analysis (MD&A),¹⁸ audited financial statements¹⁹ and supplementary data, outstanding debt detail, basic shares outstanding, and stock options/warrants data. It also contains an abundance of other pertinent information about the company and its sector, such as business segment detail, customers, end markets, competition, insight into material opportunities (and challenges and risks), significant recent events, and acquisitions.

10-Q (Quarterly Report)

The 10-Q is a quarterly report filed with the SEC by a public registrant that provides an overview of the most recent quarter and year-to-date (YTD) period.²⁰ It is less comprehensive than the 10-K, but provides financial statements as well as MD&A relating to the company's financial performance for the most recent quarter and YTD period versus the prior year periods.²¹ The 10-Q also provides the most recent share count information and may also contain the most recent stock options/warrants data. For detailed financial information on a company's final quarter of the fiscal year, the banker refers to the 8-K containing the fourth quarter earnings press release that usually precedes the filing of the 10-K.

8-K (Current Report)

The 8-K, or current report, is filed by a public registrant to report the occurrence of material corporate events or changes (“triggering event”) that are of importance to shareholders or security holders.²² For the purposes of preparing trading comps, key triggering events include, but are not limited to, earnings announcements, entry into a definitive purchase/sale agreement,²³ completion of an acquisition or disposition of assets, capital markets transactions, and Regulation FD disclosure requirements.²⁴ The corresponding 8-Ks for these events often contain important information necessary to calculate a company's updated financial statistics, ratios, and trading multiples that may not be reflected in the most recent 10-K or 10-Q (see “Adjustments for Recent Events”).

Proxy Statement

A proxy statement is a document that a public company sends to its shareholders prior to a shareholder meeting containing material information regarding matters on which the shareholders are expected to vote. It is also filed with the SEC on Schedule 14A. For the purposes of spreading trading comps, the annual proxy statement provides a basic shares outstanding count that may be more recent than that contained in the latest 10-K or 10-Q. As previously discussed, the annual proxy statement also typically contains a suggested peer group for benchmarking purposes.

Research Reports

Equity research reports provide individual analyst estimates of future company performance, which may be used to calculate forward-looking multiples. They generally include estimates of sales, EBITDA and/or EBIT, and EPS for future quarters and the future two- or three-year period (on an annual basis). More comprehensive reports provide additional estimated financial information from the research analyst's model, including key items from the income statement, balance sheet, and cash flow statement. These reports may also provide segmented financial projections, such as sales and EBIT at the business division level.

Equity research reports often provide commentary on non-recurring items and recent M&A and capital markets transactions, which are helpful for determining pro forma adjustments and normalizing financial data. They may also provide helpful sector and market information, as well as explicitly list the research analyst's view on the company's comparables universe. Initiating coverage research reports tend to be more comprehensive than normal interim reports. As a result, it is beneficial to mine these reports for financial, market, and competitive insights. Research reports can be located through various subscription financial information services such as Bloomberg, where reports are available via function: RES<GO>.

Press Releases and News Runs

A company issues a press release when it has something important to report to the public. Standard press releases include earnings announcements, declaration of dividends, and management changes, as well as M&A and capital markets transactions. Earnings announcements, which are accompanied by the filing of an 8-K, are typically issued prior to the filing of a 10-K or 10-Q. Therefore, the banker relies upon the financial data provided in the earnings announcement to update trading comps in a timely manner. A company may also release an investor presentation to accompany its quarterly earnings call, which may be helpful in readily identifying key financial data and obtaining additional color and commentary. In the event that certain financial information is not provided in the earnings press release, the banker must wait until the filing of the 10-K or 10-Q for complete information. A company's press releases and recent news articles are available on its corporate website as well as through Bloomberg.

Financial Information Services

As discussed throughout this section, Bloomberg is a key source for obtaining SEC filings, research reports, consensus estimates, and press releases, among other items. Bloomberg is also a primary source for current and historical company share price information, which is essential for calculating equity value and determining a company's current share price as a percentage of its 52-week high. Bloomberg Coverage Dashboard summarizes information for investment bankers to monitor and diligence public companies (see Appendix 1.5).

Financial information services, such as Bloomberg, may also be sourced to provide information on a company's credit ratings. If practical, however, we suggest sourcing credit ratings directly from the official Moody's, S&P, and Fitch websites and attributing such information to its original sources.²⁶

Summary of Financial Data Primary Sources

Exhibit 1.4 provides a summary of the primary sources used to obtain the necessary financial information to perform trading comps.

Equity Value

Equity value (“market capitalization”) is the value represented by a given company's basic shares outstanding plus “in-the-money” stock options,²⁹ warrants,³⁰ and convertible securities—collectively, “fully diluted shares outstanding.” It is calculated by multiplying a company's current share price³¹ by its fully diluted shares outstanding (see Exhibit 1.6).

When compared to other companies, equity value only provides a measure of relative size. Therefore, for insight on absolute and relative market performance—which is informative for interpreting multiples and framing valuation—the banker looks at the company's current share price as a percentage of its 52-week high. This is a widely used metric that provides perspective on valuation and gauges current market sentiment and outlook for both the individual company and its broader sector. If a given company's percentage is significantly out of line with that of its peers, it is generally an indicator of company-specific (as opposed to sector-specific) issues. For example, a company may have missed its earnings guidance or underperformed versus its peers over the recent quarter(s). It may also be a sign of more entrenched issues involving management, operations, or specific markets.

Calculation of Fully Diluted Shares Outstanding

A company's fully diluted shares are calculated by adding the number of shares represented by its in-the-money options, warrants, and convertible securities to its basic shares outstanding.³² A company's most recent basic shares outstanding count is typically sourced from the first page of its 10-K or 10-Q (whichever is most recent). In some cases, however, the latest proxy statement may contain more updated data and, therefore, should be used in lieu of the 10-K or 10-Q. The most recent stock options/warrants information is obtained from a company's latest 10-K or, in some cases, the 10-Q.

The incremental shares represented by a company's in-the-money options and warrants are calculated in accordance with the treasury stock method (TSM). Those shares implied by a company's in-the-money convertible and equity-linked securities are calculated in accordance with the if-converted method or net share settlement (NSS), as appropriate.

Options and Warrants—The Treasury Stock Method

The TSM assumes that all tranches of in-the-money options and warrants are exercised at their weighted average strike price with the resulting option proceeds used to repurchase outstanding shares of stock at the company's current share price. In-the-money options and warrants are those that have an exercise price lower than the current market price of the underlying company's stock. As the strike price is lower than the current market price, the number of shares repurchased is less than the additional shares outstanding from exercised options. This results in a net issuance of shares, which is dilutive.

In Exhibit 1.7, we provide an example of how to calculate fully diluted shares outstanding using the TSM.

As shown in Exhibit 1.7, the 5 million options are in-the-money as the exercise price of $18.00 is lower than the current share price of $20.00. This means that the holders of the options have the right to buy the company's shares at $18.00 and sell them at $20.00, thereby realizing the $2.00 differential. Under the TSM, it is assumed that the $18.00 of potential proceeds received by the company is used to repurchase shares that are currently trading at $20.00. Therefore, the number of shares repurchased is 90% ($18.00 / $20.00) of the options, or 4.5 million shares in total (90% × 5 million). To calculate net new shares, the 4.5 million shares repurchased are subtracted from the 5 million options, resulting in 0.5 million. These new shares are added to the company's basic shares outstanding to derive fully diluted shares of 100.5 million.

Convertible and Equity-Linked Securities

Outstanding convertible and equity-linked securities also need to be factored into the calculation of fully diluted shares outstanding. Convertible and equity-linked securities bridge the gap between traditional debt and equity, featuring characteristics of both. They include a broad range of instruments, such as traditional cash-pay convertible bonds, convertible hybrids, perpetual convertible preferred, and mandatory convertibles.³³

This section focuses on the traditional cash-pay convertible bond as it is the most “plain-vanilla” and commonly issued structure. A cash-pay convertible bond (“convert”) represents a straight debt instrument and an embedded equity call option that provides for the convert to be exchanged into a defined number of shares of the issuer's common stock under certain circumstances. The value of the embedded call option allows the issuer to pay a lower coupon than a straight debt instrument of the same credit. The strike price of the call option (“conversion price”), which represents the share price at which equity would be issued to convertible holders if the bonds were converted, is typically set at a premium to the company's underlying share price at the time of issuance.

For the purposes of performing trading comps, to calculate fully diluted shares outstanding, it is standard practice to first determine whether the company's outstanding converts are in-the-money, meaning that the current share price is above the conversion price. Cash-pay converts are converted into additional shares in accordance with either the if-converted method (physical settlement) or net share settlement, as applicable. Out-of-the-money converts, by contrast, remain treated as debt. Proper treatment of converts requires a careful reading of the relevant footnotes in the company's 10-K or prospectus for the security.

If-Converted Method In accordance with the if-converted method, when performing trading comps, in-the-money converts are converted into additional shares by dividing the convert's amount outstanding by its conversion price.³⁴ Once converted, the convert is treated as equity and included in the calculation of the company's fully diluted shares outstanding and equity value. The equity value represented by the convert is calculated by multiplying the new shares outstanding from conversion by the company's current share price. Accordingly, the convert must be excluded from the calculation of the company's total debt.

As shown in Exhibit 1.8, as the company's current share price of $20.00 is greater than the conversion price of $15.00, we determine that the $150 million convert is in-the-money. Therefore the convert's amount outstanding is simply divided by the conversion price to calculate new shares of 10 million ($150 million / $15.00). The new shares from conversion are then added to the company's basic shares outstanding of 100 million and net new shares from in-the-money options of 0.5 million to calculate fully diluted shares outstanding of 110.5 million.

The conversion of in-the-money converts also requires an upward adjustment to the company's net income to account for the foregone interest expense payments associated with the coupon on the convert. This amount must be tax-effected before being added back to net income. Therefore, while conversion is typically EPS dilutive due to the additional share issuance, net income is actually higher on a pro forma basis.

Net Share Settlement Net share settlement is an increasingly common feature in convertible bonds. For converts issued with a net share settlement accounting feature,³⁵ the issuer is permitted to satisfy the face (or accreted) value of an in-the-money convert with at least a portion of cash upon conversion. Only the value represented by the excess of the current share price over the conversion price is assumed to be settled with the issuance of additional shares,³⁶ which results in less share issuance. This serves to limit the dilutive effects of conversion by affording the issuer TSM accounting treatment.

As shown in Exhibit 1.9, the if-converted method results in incremental shares of 10 million shares, while NSS results in incremental shares of only 2.5 million. The NSS calculation is conducted by first multiplying the number of underlying shares in the convert of 10 million by the company's current share price of $20.00 to determine the implied conversion value of $200 million. The $50 million spread between the conversion value and par ($200 million − $150 million) is then divided by the current share price to determine the number of incremental shares from conversion of 2.5 million ($50 million / $20.00).³⁷ The $150 million face value of the convert remains treated as debt due to the fact that the issuer typically has the right to settle this amount in cash.

Enterprise Value

Enterprise value (“total enterprise value” or “firm value”) is the sum of all ownership interests in a company and claims on its assets from both debt and equity holders. As the graphic in Exhibit 1.10 depicts, it is defined as equity value + total debt + preferred stock + noncontrolling interest³⁸ – cash and cash equivalents. The equity value component is calculated on a fully diluted basis.

Theoretically, enterprise value is considered independent of capital structure, meaning that changes in a company's capital structure do not affect its enterprise value. For example, if a company raises additional debt that is held on the balance sheet as cash, its enterprise value remains constant as the new debt is offset by the increase in cash (i.e., net debt remains the same, see Scenario I in Exhibit 1.11). Similarly, if a company issues equity and uses the proceeds to repay debt, the incremental equity value is offset by the decrease in debt on a dollar- for-dollar basis (see Scenario II in Exhibit 1.11).³⁹ Therefore, these transactions are enterprise value neutral.

In both Scenario I and II, enterprise value remains constant despite a change in the company's capital structure. Hence, similar companies would be expected to have consistent enterprise value multiples despite differences in capital structure. One notable exception concerns highly leveraged companies, which may trade at a discount relative to their peers due to the perceived higher risk of financial distress⁴⁰ and potential constraints to growth.

Size: Key Financial Data

• Sales (or revenue) is the first line item, or “top line,” on an income statement. Sales represents the total dollar amount realized by a company through the sale of its products and services during a given time period. Sales levels and trends are a key factor in determining a company's relative positioning among its peers. All else being equal, companies with greater sales volumes tend to benefit from scale, market share, purchasing power, and lower risk profile, and are often rewarded by the market with a premium valuation relative to smaller peers.
• Gross Profit, defined as sales less cost of goods sold (COGS),⁴¹ is the profit earned by a company after subtracting costs directly related to the production of its products and services. As such, it is a key indicator of operational efficiency and pricing power, and is usually expressed as a percentage of sales for analytical purposes (gross profit margin, see Exhibit 1.12). For example, if a company sells a product for $100, and that product costs $60 in materials, manufacturing, and direct labor to produce, then the gross profit on that product is $40 and the gross profit margin is 40%.
• EBITDA (earnings before interest, taxes, depreciation and amortization) is an important measure of profitability. As EBITDA is a non-GAAP financial measure and typically not reported by public filers, it is generally calculated by taking EBIT (or operating income/profit as often reported on the income statement) and adding back the depreciation and amortization (D&A) as sourced from the cash flow statement.⁴² EBITDA is a widely used proxy for operating cash flow as it reflects the company's total cash operating costs for producing its products and services. In addition, EBITDA serves as a fair “apples-to-apples” means of comparison among companies in the same sector because it is free from differences resulting from capital structure (i.e., interest expense) and tax regime (i.e., tax expense).
• EBIT (earnings before interest and taxes) is often the same as reported operating income, operating profit, or income from operations⁴³ on the income statement found in a company's SEC filings. Like EBITDA, EBIT is independent of tax regime and serves as a useful metric for comparing companies with different capital structures. It is, however, less indicative as a measure of operating cash flow than EBITDA because it includes non-cash D&A expense. Furthermore, D&A reflects discrepancies among different companies in capital spending and/or depreciation policy as well as acquisition histories (amortization).
• Net income (“earnings” or the “bottom line”) is the residual profit after all of a company's expenses have been netted out. Net income can also be viewed as the earnings available to equity holders once all of the company's obligations have been satisfied (e.g., to suppliers, vendors, service providers, employees, utilities, lessors, lenders, state and local treasuries). Wall Street tends to view net income on a per share basis (i.e., earnings per share or EPS).

Profitability

• Gross profit margin (“gross margin”) measures the percentage of sales remaining after subtracting COGS (see Exhibit 1.12). It is driven by a company's direct cost per unit, such as materials, manufacturing, and direct labor involved in production. These costs are typically largely variable, as opposed to corporate overhead, which is more fixed in nature.⁴⁴ Companies ideally seek to increase their gross margin through a combination of improved sourcing/procurement of raw materials and enhanced pricing power, as well as by improving the efficiency of manufacturing facilities and processes.

• EBITDA and EBIT margin are accepted standards for measuring a company's operating profitability (see Exhibit 1.13). Accordingly, they are used to frame relative performance both among peer companies and across sectors.

• Net income margin measures a company's overall profitability as opposed to its operating profitability (see Exhibit 1.14). It is net of interest expense and, therefore, affected by capital structure. As a result, companies with similar operating margins may have substantially different net income margins due to differences in leverage. Furthermore, as net income is impacted by taxes, companies with similar operating margins may have varying net income margins due to different tax rates.

Growth Profile

A company's growth profile is a critical value driver. In assessing a company's growth profile, the banker typically looks at historical and estimated future growth rates as well as compound annual growth rates (CAGRs) for selected financial statistics (see Exhibit 1.15).

Historical annual EPS data is typically sourced directly from a company's 10-K or a financial information service that sources SEC filings, such as Bloomberg. As with the calculation of any financial statistic, historical EPS must be adjusted for non-recurring items to be meaningful. The data that serves as the basis for a company's projected 1-year, 2-year, and long-term⁴⁵ EPS growth rates is generally obtained from consensus estimates.

Return on Investment

• Return on invested capital (ROIC) measures the return generated by all capital provided to a company. As such, ROIC utilizes a pre-interest earnings statistic in the numerator, such as EBIT or tax-effected EBIT (also known as NOPAT or EBIAT) and a metric that captures both debt and equity in the denominator (see Exhibit 1.16). The denominator is typically calculated on an average basis (e.g., average of the balances as of the prior annual and most recent periods).

• Return on equity (ROE) measures the return generated on the equity provided to a company by its shareholders. As a result, ROE incorporates an earnings metric net of interest expense, such as net income, in the numerator and average shareholders' equity in the denominator (see Exhibit 1.17). ROE is an important indicator of performance as companies are intently focused on shareholder returns.

• Return on assets (ROA) measures the return generated by a company's asset base, thereby providing a barometer of the asset efficiency of a business. ROA typically utilizes net income in the numerator and average total assets in the denominator (see Exhibit 1.18).

• Dividend yield is a measure of returns to shareholders, but from a different perspective than earnings-based ratios. Dividend yield measures the annual dividends per share paid by a company to its shareholders (which can be distributed either in cash or additional shares), expressed as a percentage of its share price. Dividends are typically paid on a quarterly basis and, therefore, must be annualized to calculate the implied dividend yield (see Exhibit 1.19).⁴⁶ For example, if a company pays a quarterly dividend of $0.05 per share ($0.20 per share on an annualized basis) and its shares are currently trading at $10.00, the dividend yield is 2% (($0.05 × 4 payments) / $10.00).

Credit Profile

Leverage Leverage refers to a company's debt level. It is typically measured as a multiple of EBITDA (e.g., debt-to-EBITDA) or as a percentage of total capitalization (e.g., debt-to-total capitalization). Both debt and equity investors closely track a company's leverage as it reveals a great deal about financial policy, risk profile, and capacity for growth. As a general rule, the higher a company's leverage, the higher its risk of financial distress due to the burden associated with greater interest expense and principal repayments.

• Debt-to-EBITDA depicts the ratio of a company's debt to its EBITDA, with a higher multiple connoting higher leverage (see Exhibit 1.20). It is generally calculated on the basis of LTM financial statistics. There are several variations of this ratio, including total debt-to-EBITDA, senior secured debt- to-EBITDA, net debt-to-EBITDA, and total debt-to-(EBITDA less capex). As EBITDA is typically used as a rough proxy for operating cash flow, this ratio can be viewed as a measure of how many years of a company's cash flows are needed to repay its debt.

• Debt-to-total capitalization measures a company's debt as a percentage of its total capitalization (debt + preferred stock + noncontrolling interest + equity) (see Exhibit 1.21). This ratio can be calculated on the basis of book or market values depending on the situation. As with debt-to-EBITDA, a higher debt-to-total capitalization ratio connotes higher debt levels and risk of financial distress.

Coverage

Coverage is a broad term that refers to a company's ability to meet (“cover”) its interest expense obligations. Coverage ratios are generally comprised of a financial statistic representing operating cash flow (e.g., LTM EBITDA) in the numerator and LTM interest expense in the denominator. There are several variations of the coverage ratio, including EBITDA-to-interest expense, (EBITDA less capex)-to-interest expense, and EBIT-to-interest expense (see Exhibit 1.22). Intuitively, the higher the coverage ratio, the better positioned the company is to meet its debt obligations and, therefore, the stronger its credit profile.

Credit Ratings

A credit rating is an assessment⁴⁷ by an independent rating agency of a company's ability and willingness to make full and timely payments of amounts due on its debt obligations. Credit ratings are typically required for companies seeking to raise debt financing in the capital markets as only a limited class of investors will participate in a corporate debt offering without an assigned credit rating on the new issue.⁴⁸

The three primary credit rating agencies are Moody's, S&P, and Fitch. Nearly every public debt issuer receives a rating from Moody's, S&P, and/or Fitch. Moody's uses an alphanumeric scale, while S&P and Fitch both use an alphabetic system combined with pluses (+) and minuses (–) to rate the creditworthiness of an issuer. The ratings scales of the primary rating agencies are shown in Exhibit 1.23.

Supplemental Financial Concepts and Calculations

Calculation of LTM Financial Data

U.S. public filers are required to report their financial performance on a quarterly basis, including a full year report filed at the end of the fiscal year. Therefore, in order to measure financial performance for the most recent annual or LTM period, the company's financial results for the previous four quarters are summed. This financial information is sourced from the company's most recent 10-K and 10-Q, as appropriate. As previously discussed, however, prior to the filing of the 10-Q or 10-K, companies typically issue a detailed earnings press release in an 8-K with the necessary financial data to help calculate LTM performance. Therefore, it may be appropriate to use a company's earnings announcement to update trading comps on a timely basis.

As the formula in Exhibit 1.24 illustrates, LTM financials are typically calculated by taking the full prior fiscal year's financial data, adding the YTD financial data for the current year period (“current stub”), and then subtracting the YTD financial data from the prior year (“prior stub”).

In the event that the most recent quarter is the fourth quarter of a company's fiscal year, then no LTM calculations are necessary as the full prior fiscal year (as reported) serves as the LTM period. Exhibit 1.25 shows an illustrative calculation for a given company's LTM sales for the period ending 9/30/2012.

Calendarization of Financial Data

The majority of U.S. public filers report their financial performance in accordance with a fiscal year (FY) ending December 31, which corresponds to the calendar year (CY) end. Some companies, however, report on a different schedule (e.g., a fiscal year ending April 30). Any variation in fiscal year ends among comparable companies must be addressed for benchmarking purposes. Otherwise, the trading multiples will be based on financial data for different periods and, therefore, not truly “comparable.”

To account for variations in fiscal year ends among comparable companies, each company's financials are adjusted to conform to a calendar year end in order to produce a “clean” basis for comparison, a process known as “calendarization.” This is a relatively straightforward algebraic exercise, as illustrated by the formula in Exhibit 1.26, used to calendarize a company's fiscal year sales projection to produce a calendar year sales projection.⁴⁹

Exhibit 1.27 provides an illustrative calculation for the calendarization of a company's calendar year 2012 estimated (E) sales, assuming a fiscal year ending April 30.

Adjustments for Non-Recurring Items

To assess a company's financial performance on a “normalized” basis, it is standard practice to adjust reported financial data for non-recurring items, a process known as “scrubbing” or “sanitizing” the financials. Failure to do so may lead to the calculation of misleading ratios and multiples, which, in turn, may produce a distorted view of valuation. These adjustments involve the add-back or elimination of one-time charges and gains, respectively, to create a more indicative view of ongoing company performance. Typical charges include those incurred for restructuring events (e.g., store/plant closings and headcount reduction), losses on asset sales, changes in accounting principles, inventory write-offs, goodwill impairment, extinguishment of debt, and losses from litigation settlements, among others. Typical benefits include gains from asset sales, favorable litigation settlements, and tax adjustments, among others.

Non-recurring items are often described in the MD&A section and financial footnotes in a company's public filings (e.g., 10-K and 10-Q) and earnings announcements. These items are often explicitly depicted as “non-recurring,” “extraordinary,” “unusual,” or “one-time.” Therefore, the banker is encouraged to comb electronic versions of the company's public filings and earnings announcements using word searches for these adjectives. Often, non-recurring charges or benefits are explicitly broken out as separate line items on a company's reported income statement and/or cash flow statement. Research reports can be helpful in identifying these items, while also providing color commentary on the reason they occurred.

In many cases, however, the banker must exercise discretion as to whether a given charge or benefit is non-recurring or part of normal business operations. This determination is sometimes relatively subjective, further compounded by the fact that certain events may be considered non-recurring for one company, but customary for another. For example, a generic pharmaceutical company may find itself in court frequently due to lawsuits filed by major drug manufacturers related to patent challenges. In this case, expenses associated with a lawsuit should not necessarily be treated as non-recurring because these legal expenses are a normal part of ongoing operations. While financial information services such as Bloomberg provide a breakdown of recommended adjustments that can be helpful in identifying potential non-recurring items, ultimately the banker should exercise professional judgment.

When adjusting for non-recurring items, it is important to distinguish between pre-tax and after-tax amounts. For a pre-tax restructuring charge, for example, the full amount is simply added back to calculate adjusted EBIT and EBITDA. To calculate adjusted net income, however, the pre-tax restructuring charge needs to be tax-effected⁵⁰ before being added back. Conversely, for after-tax amounts, the disclosed amount is simply added back to net income, but must be “grossed up” at the company's tax rate (t) (i.e., divided by (1 – t)) before being added back to EBIT and EBITDA.

Exhibit 1.28 provides an illustrative income statement for the fiscal year 2011 as it might appear in a 10-K. Let's assume the corresponding notes to these financials mention that the company recorded one-time charges related to an inventory write-down ($5 million pre-tax) and restructuring expenses from downsizing the sales force ($10 million pre-tax). Provided we gain comfort that these charges are truly non-recurring, we would need to normalize the company's earnings statistics accordingly for these items in order to arrive at adjusted EBIT, EBITDA, and diluted EPS.

As shown in Exhibit 1.29, to calculate adjusted EBIT and EBITDA, we add back the full pre-tax charges of $5 million and $10 million ($15 million in total). This provides adjusted EBIT of $150 million and adjusted EBITDA of $200 million. To calculate adjusted net income and diluted EPS, however, the tax expense on the incremental $15 million pre-tax earnings must be subtracted. Assuming a 40% marginal tax rate, we calculate tax expense of $6 million and additional net income of $9 million ($15 million – $6 million). The $9 million is added to reported net income, resulting in adjusted net income of $69 million. We then divide the $69 million by weighted average fully diluted shares outstanding of 30 million to calculate adjusted diluted EPS of $2.30.

Adjustments for Recent Events

In normalizing a company's financials, the banker must also make adjustments for recent events, such as M&A transactions, financing activities, conversion of convertible securities, stock splits, or share repurchases in between reporting periods. Therefore, prior to performing trading comps, the banker checks company SEC filings (e.g., 8-Ks, registration statements/prospectuses⁵¹) and press releases since the most recent reporting period to determine whether the company has announced such activities.

For a recently announced M&A transaction, for example, the company's financial statements must be adjusted accordingly. The balance sheet is adjusted for the effects of the transaction by adding the purchase price financing (including any refinanced or assumed debt), while the LTM income statement is adjusted for the target's incremental sales and earnings. Equity research analysts typically update their estimates for a company's future financial performance promptly following the announcement of an M&A transaction. Therefore, the banker can use updated consensus estimates in combination with the pro forma balance sheet to calculate forward-looking multiples.⁵²

Calculation of Key Trading Multiples

Once the key financial statistics are spread, the banker proceeds to calculate the relevant trading multiples for the comparables universe. While various sectors may employ specialized or sector-specific valuation multiples (see Exhibit 1.33), the most generic and widely used multiples employ a measure of market valuation in the numerator (e.g., enterprise value, equity value) and a universal measure of financial performance in the denominator (e.g., EBITDA, net income). For enterprise value multiples, the denominator employs a financial statistic that flows to both debt and equity holders, such as sales, EBITDA, and EBIT. For equity value (or share price) multiples, the denominator must be a financial statistic that flows only to equity holders, such as net income (or diluted EPS). Among these multiples, EV/EBITDA and P/E are the most common.

The following sections provide an overview of the more commonly used equity value and enterprise value multiples.

Equity Value Multiples

Price-to-Earnings Ratio / Equity Value-to-Net Income Multiple

The P/E ratio, calculated as current share price divided by diluted EPS (or equity value divided by net income), is the most widely recognized trading multiple. Assuming a constant share count, the P/E ratio is equivalent to equity value-to-net income. These ratios can also be viewed as a measure of how much investors are willing to pay for a dollar of a company's current or future earnings. P/E ratios are typically based on forward-year EPS⁵³ (and, to a lesser extent, LTM EPS) as investors are focused on future growth. Companies with higher P/Es than their peers tend to have higher earnings growth expectations.

The P/E ratio is particularly relevant for mature companies that have a demonstrated ability to consistently grow earnings. However, while the P/E ratio is broadly used and accepted, it has certain limitations. For example, it is not relevant for companies with little or no earnings as the denominator in these instances is de minimis, zero, or even negative. In addition, as previously discussed, net income (and EPS) is net of interest expense and, therefore, dependent on capital structure. As a result, two otherwise similar companies in terms of size and operating margins can have substantially different net income margins (and consequently P/E ratios) due to differences in leverage. Similarly, accounting discrepancies, such as for depreciation or taxes, can also produce meaningful disparities in P/E ratios among comparable companies.

The two formulas for calculating the P/E ratio (both equivalent, assuming a constant share count) are shown in Exhibit 1.30.

Enterprise Value Multiples

Given that enterprise value represents the interests of both debt and equity holders, it is used as a multiple of unlevered financial statistics such as sales, EBITDA, and EBIT. The most generic and widely used enterprise value multiples are EV/EBITDA, EV/EBIT, and EV/sales (see Exhibits 1.31 and 1.32). As with P/E ratios, enterprise value multiples tend to focus on forward estimates in addition to LTM statistics for framing valuation.

Enterprise Value-to-EBITDA and Enterprise Value-to-EBIT Multiples

EV/EBITDA serves as a valuation standard for most sectors. It is independent of capital structure and taxes, as well as any distortions that may arise from differences in D&A among different companies. For example, one company may have spent heavily on new machinery and equipment in recent years, resulting in increased D&A for the current and future years, while another company may have deferred its capital spending until a future period. In the interim, this situation would produce disparities in EBIT margins between the two companies that would not be reflected in EBITDA margins.

For the reasons outlined above, as well as potential discrepancies due to acquisition-related amortization, EV/EBIT is less commonly used than EV/EBITDA. However, EV/EBIT may be helpful in situations where D&A is unavailable (e.g., when valuing divisions of public companies) or for companies with high capex.

Enterprise Value-to-Sales Multiple

EV/sales is also used as a valuation metric, although it is typically less relevant than the other multiples discussed. Sales may provide an indication of size, but it does not necessarily translate into profitability or cash flow generation, both of which are key value drivers. Consequently, EV/sales is used largely as a sanity check on the earnings-based multiples discussed above.

In certain sectors, however, as well as for companies with little or no earnings, EV/sales may be relied upon as a meaningful reference point for valuation. For example, EV/sales may be used to value an early stage technology company that is aggressively growing sales, but has yet to achieve profitability.

Sector-Specific Multiples Many sectors employ specific valuation multiples in addition to, or instead of, the traditional metrics previously discussed. These multiples use an indicator of market valuation in the numerator and a key sector-specific financial, operating, or production/capacity statistic in the denominator. Selected examples are shown in Exhibit 1.33. Bloomberg provides many data sets and analyses specific to individual industries via Bloomberg Industries (BI<GO>). Appendix 1.6 displays an example of comparable companies for Basic & Diversified Chemicals, in which P/E, EV/EBITDA, and P/FCF are displayed.

Return on Invested Capital

For ROIC, we calculated 21.1% (see Exhibit 1.49) by dividing Gasparro's LTM 9/30/2012 adjusted EBIT of $725 million (as calculated in Exhibit 1.47) by the sum of its average net debt and shareholders' equity balances for the periods ending 12/31/2011 and 9/30/2012 ($725 million / (($1,875 million – $75 million + $1,600 million) + ($1,850 million – $100 million + $1,725 million) / 2)).

Return on Equity

For ROE, we calculated 23.3% by dividing Gasparro's LTM 9/30/2012 adjusted net income of $387.5 million (as calculated in Exhibit 1.47) by its average shareholders' equity balance for the periods ending 12/31/2011 and 9/30/2012 (($1,600 million + $1,725 million) / 2).

Return on Assets

For ROA, we calculated 7.9% by dividing Gasparro's LTM 9/30/2012 adjusted net income of $387.5 million by its average total assets for the periods ending 12/31/2011 and 9/30/2012 (($4,825 million + $5,000 million) / 2).

Dividend Yield

To calculate dividend yield, we annualized Gasparro's dividend payment of $0.25 per share for the most recent quarter (see Exhibit 1.41), which implied an annual dividend payment of $1.00 per share. We checked recent press releases to ensure there were no changes in dividend policy after the filing of the 10-Q. The implied annualized dividend payment of $1.00 per share was then divided by Gasparro's current share price of $50.00 to calculate an implied annual dividend yield of 2%.

LTM Credit Statistics

EBITDA-to-Interest Expense

For EBITDA-to-interest expense, we divided Gasparro's LTM 9/30/2012 adjusted EBITDA of $900 million by its interest expense of $100 million for the same period. This provided a ratio of 9.0x. We also calculated Gasparro's (EBITDA – capex)-to-interest expense and EBIT-to-interest expense ratios at 7.0x and 7.3x, respectively.

Trading Multiples

In the “Trading Multiples” section, we entered consensus estimates for Gasparro's 2012E, 2013E, and 2014E sales, EBITDA, EBIT, and EPS (see Exhibit 1.51). These estimates, along with the calculated enterprise and equity values, were used to calculate forward trading multiples. Gasparro's LTM adjusted financial data is also linked to this section and used to calculate trailing trading multiples.

Enterprise Value Multiples

For enterprise value-to-LTM EBITDA, we divided Gasparro's enterprise value of $6,750 million by its LTM 9/30/2012 adjusted EBITDA of $900 million, providing a multiple of 7.5x. For EV/2012E EBITDA, we divided the same enterprise value of $6,750 million by Gasparro's 2012E EBITDA of $950 million to calculate a multiple of 7.1x. This same methodology was used for EV/2013E EBITDA and EV/2014E EBITDA, as well as for the trailing and forward sales and EBIT enterprise value multiples.

Price-to-Earnings Ratio

The approach for calculating P/E mirrors that for EV/EBITDA. We divided Gasparro's current share price of $50.00 by its LTM, 2012E, 2013E, and 2014E EPS of $3.88, $4.45, $5.00, and $5.50, respectively. These calculations provided P/E ratios of 12.9x, 11.2x, 10.0x, and 9.1x, respectively.

Free Cash Flow Yield

Free cash flow (FCF) generation is an important metric for determining valuation. FCF is an indicator of a company's ability to return capital to shareholders or repay debt, which accrues to equity holders. Therefore, many investors focus on FCF yield, calculated as (cash from operations – capex) / market capitalization or FCF per share / share price. Gasparro's FCF yield for LTM, 2012E, 2013E, and 2014E is 6.3%, 7.0%, 7.5%, and 8.3%, respectively.