Do You Use Diluted Shares Outstanding For Comparable Valuation?

Do You Use Diluted Shares Outstanding For Comparable Valuation? This is a critical question when conducting comparable company analysis (Comps), a widely used valuation technique. COMPARE.EDU.VN provides in-depth analysis on financial topics that helps you make informed financial decisions. Understanding the nuances of share counts and their impact on valuation multiples is essential for accurate financial assessments.

1. Comparable Company Analysis (Comps): An Overview

Comparable Company Analysis, or “Comps,” is a relative valuation method that values a company by comparing its valuation multiples to those of its peers. These multiples usually represent a ratio of a valuation metric, such as Market Capitalization or Enterprise Value, to a financial performance metric, like Earnings/Earnings Per Share (EPS), Sales, or EBITDA.

1.1 What Comps Entail

Comps operate on the principle that similar companies should trade at similar multiples, assuming all other conditions are equal. For instance, businesses in the same industry with comparable growth rates and risk profiles should have similar EV/EBITDA multiples.

1.2 Why Comps Are Favored

Ease of Use: Comps are relatively straightforward to execute, with data usually available, particularly for publicly traded comparables.
Market Benchmark: Assuming efficient markets, Comps provide a reasonable valuation range, while other methods like DCF are sensitive to underlying assumptions.

Given these benefits, Comps are widely utilized by investment bankers, sell-side research analysts, private equity investors, and other market participants. However, it’s important to acknowledge their limitations.

1.3 Advantages and Disadvantages of Comps

Pros	Cons
– Easy to calculate using widely available data – Easy to communicate across a variety of market participants – Determine a benchmark value for multiples used in valuation – Provide a useful way to assess market assumptions of fundamental characteristics baked into valuations	– Influenced by temporary market conditions or non-fundamental factors – Not useful when there are few or no comparable companies – Can be difficult to find appropriate comparable companies for various reasons – Less reliable when comparable companies are thinly traded

2. Steps to Performing a Comparable Companies Analysis

A structured approach is vital for an effective Comps analysis. Remember “C.V.S.” to guide you:

Confirm relevant peer universe.
Validate key fundamental metrics.
Select appropriate multiple for valuation.

2.1 Confirming the Peer Universe

Selecting the right peer group is crucial in a Comps analysis because it heavily influences the valuation outcome. A company might be compared across two industries because of its business activities, such as an internet retail company. Some comparables may need to be adjusted or excluded because they operate across several industry segments. Peer selection is somewhat subjective, requiring sound judgment.

2.2 Validating Key Fundamental Metrics

Analysts can use trailing (historical) or forward (forecast) performance metrics when conducting a Comps valuation. Although future metrics are often preferred, they come with potential pitfalls related to forecasting. Forecasted EBITDA and Earnings/EPS are subject to uncertainties, and the projections could be significantly off.

2.3 Selecting the Appropriate Multiple

Adjust performance metrics for one-time charges and non-recurring items like asset sales, legal expenses, or restructuring charges. It’s essential to use “clean” numbers for all companies in the analysis to ensure an “apples-to-apples” comparison. This becomes more complex when using future performance metrics because non-recurring items may not yet be known.

3. Key Assumptions & Projections in Comps Analysis

Before diving deeper, let’s quickly review key assumptions and projections required for a Comps analysis:

Peer Universe: A carefully chosen group of competitor or similar companies to determine a benchmark valuation.
EBITDA: Earnings before Interest, Taxes, Depreciation & Amortization – both historical and projected.
EPS: Earnings Per Share – historical and projected.

4. Types of Multiples Used in Comps

Multiples in Comps analyses can be broadly classified into two categories:

Operating Multiples: Refer to the operating results of the entire business.
Equity Multiples: Reflect the value created for equity shareholders.

4.1 Common Multiples

EV/Sales: Enterprise Value divided by Sales/Revenue (Operating multiple).
EV/EBITDA: Enterprise Value divided by EBITDA (Operating multiple).
P/E: Price/Earnings ratio (Equity multiple), calculated as Share Price ÷ EPS or Market Capitalization ÷ Earnings.
P/B: Price/Book ratio (Equity multiple), calculated as Share Price ÷ Book Value per Share or Market Capitalization ÷ Shareholders’ Equity.
P/(Levered) Cash Flow: Price/Cash Flow ratio (Equity multiple), calculated as Share Price ÷ Levered Cash Flow per Share or Market Capitalization ÷ Levered Cash Flow.

When using Operating Multiples, Enterprise Value is used as the numerator, while Market Capitalization serves as the numerator for Equity Multiples. Avoid mixing these; use EV with enterprise-related metrics and Market Capitalization with equity-related metrics.

4.2 Recap on Operating Multiples

The most commonly used Operating multiples are EV/Sales and EV/EBITDA.
Operating multiples disregard financial leverage (Debt) and often Depreciation & Amortization.
They value the total company, not just common stock (Equity).
Investment bankers and private equity investors frequently use them.

4.3 Recap on Equity Multiples

The most commonly used Equity multiples are P/E, P/B, and P/Cash Flow (Levered).
Equity multiples ignore cash flow to Debt holders.
Investment bankers and equity analysts frequently use them.

In practice, EV/EBITDA (an Operating multiple) and P/E (an Equity multiple) are predominantly used. However, familiarity with other types of multiples is valuable.

5. Specific Use Cases for Different Multiples

5.1 Price/Sales Multiples

Price/Sales multiples are typically used for companies with negative, highly volatile, or abnormally high/low EPS. Fast-growing companies with no earnings may be valued using multiples of Sales. Sales numbers provide stability and lower accounting distortion. However, Sales as a valuation basis does not account for profitability, and growth companies might receive high valuations regardless of earnings or cash flow.

5.2 Price/Book Multiples

Price/Book multiples are often employed to value financial services companies due to the liquid nature of their balance sheets. These multiples can also value companies with no or highly variable earnings, or those not expected to continue as a going concern. However, Price/Book ratios can be highly idiosyncratic due to the function of past business activities.

5.3 Cash Flow Multiples

Cash Flow multiples use estimates of Cash Flow, such as EBITDA, Operating Cash Flow, Free Cash Flow, and Levered Free Cash Flow, as a valuation indicator. These multiples often outperform Earnings multiples because they ignore accrual-based accounting and are less prone to management manipulation. The reciprocals of these multiples are used to produce Cash Flow Yields, which are benchmarked against treasury and dividend yields.

6. Pitfalls to Avoid in Comps Analysis

Common pitfalls in building a Comps analysis include:

Selecting an inappropriate peer universe.
Including one-off and recurring items in historical/projected EBITDA and EPS.
Choosing the wrong multiple for valuation.

Again, remember “C.V.S.”: Confirm relevant peer universe, Validate key fundamental metrics, and Select appropriate multiple for valuation.

7. Steps for Executing a Comps Valuation

Select a Peer Universe: Choose a group of similar companies with comparable industries and fundamental characteristics.
Calculate Market Capitalization: Equal to Share price × Number of Shares Outstanding.
Calculate Enterprise Value: Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash.
Historical & Projected Financials: Use historical financials from filings and projections from management, sell-side equity analysts, etc.
Spread Multiples: Calculate EV/EBITDA and P/E multiples using Market Capitalization, Enterprise Value, and historical/projected financials.
Value Target Company: Choose the appropriate benchmark valuation multiple for the peer group and value the target company based on that multiple. Typically, an average or median is used.

8. Information Sources for Comps

Peer Universe: Company filings, Research Reports, Bloomberg, or FactSet
Historical Financial Results: SEC.gov provides access to company annual reports (10-K), Quarterly reports (10-Q), and investor Prospectuses.
Financial Projections: Management estimates, sell-side equity analyst estimates, and internal estimates.

9. Selecting a Peer Universe: A Closer Look

To accurately calculate Comps, you must find companies operating in the same industry as the company being valued. Confirm relevant peer universe, Validate key fundamental metrics, and Select appropriate multiple for valuation.

9.1 Approaches to Picking a Peer Universe

Instruction from Deal Team: The investment banking deal team or Managing Director (MD) will direct you to use specific comparable companies.
Bank Resources Search: Conduct a search using bank resources (Bloomberg, FactSet, Analyst Reports) and screen for relevance.

9.2 Resources for Finding Peers

Company Filings: Refer to the “Competitors” section in company filings (10Ks, 10Qs, Prospectuses), accessible via the SEC website (http://www.sec.gov/).
Sell-side Equity Analyst Research Reports: Look for initiation reports or industry reports with comprehensive lists of peer companies.
Bloomberg: Use the Supply Chain page on Bloomberg by typing <> Equity SPLC . This page provides a snapshot of a company’s suppliers, customers, and peers.

Remember, perfect comparable companies are rare. Narrow your search using characteristics like Sector, Products & services sold, Customer base, Distribution channel, and Geography. Pizza Hut and Domino’s, Home Depot and Lowe’s, or Pepsi and Coca-Cola are close examples of nearly perfect comparables.

10. Market Capitalization & Enterprise Value: Calculation and Significance

Once you’ve selected the peer universe, gather the necessary financials to calculate multiples. Databases like Capital IQ and FactSet can expedite this process, but always verify against GAAP data in SEC filings (10-Qs and 10-Ks).

10.1 Essential Financial Information

Market Capitalization (Stock Price × Shares Outstanding)
Enterprise Value (Market Value + Net Debt + Preferred Stock + Minority Interest – Cash)
Earnings per Share (EPS, Net Income ÷ Shares Outstanding)
Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Market Capitalization reflects the total equity value of a company without considering capital structure. It’s useful for common stock investors who typically don’t have a majority stake.

Market Capitalization = Stock Price × Shares Outstanding

Stock price comes from financial software or reliable internet pricing services. Ensure it’s the closing price as of the analysis date.

10.2 Basic vs. Diluted Shares Outstanding

There are two types of Shares Outstanding: Basic and Diluted. Basic shares are on the first page of a company’s 10-K or 10-Q. Diluted shares account for the conversion of options, warrants, and convertible preferred stock. Using diluted shares prevents an underestimate of valuation.

Diluted shares outstanding can be obtained from the EPS footnotes or calculated using footnotes listing management stock options, warrants, and convertible preferred stock.

10.3 Enterprise Value (EV): A Comprehensive Measure

Enterprise Value (EV) represents the total value of a company, incorporating all capital structure components. It’s useful for strategic and private equity investors, representing the takeover value of the company before any control premium.

EV = Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash

10.4 Components of Enterprise Value

Market Capitalization: Total equity value of the company (Stock Price × Shares Outstanding) using Basic or Diluted shares outstanding.
Debt: Short and long-term debt from the company’s balance sheet, including current portions of long-term debt.
Preferred Stock: Listed in the Equity section of the balance sheet, preferred stock has debt-like (interest payments) and equity-like qualities (convertibility, voting rights). Include mandatorily redeemable and convertible preferred stock where conversion price exceeds stock price.
Minority Interest: Equity interest that other entities have in a division (subsidiary) of the company (when the company owns more than 50% but less than 100% of the equity). Minority Interest is treated as a liability on the Balance Sheet.

10.5 Why Cash Is Deducted in Enterprise Value

Cash is subtracted from Enterprise Value because excess Cash is considered a non-operating asset that can be used to pay down debt, reducing the company’s Enterprise Value. “Excess cash” refers to cash not needed for business operations.

11. Historical & Projected Financials: Gathering and Adjusting Data

Two fundamental metrics are always required: EPS and EBITDA, which form the denominators of the multiples. Historical financial results and projected financial results are used.

11.1 Historical EPS

Historical EPS comes directly from a company’s income statement in the 10-K, 10-Q, or earnings press release. Adjust Historical EPS for non-recurring items like restructuring charges, extraordinary gains/losses, etc. Management often details these adjustments in press releases or the Management Discussion & Analysis (MD&A) section of filings.

11.2 Projected EPS

Projected EPS can be derived from:

Management estimates
Consensus analyst estimates from aggregators like Thomson One, Capital IQ, or Zacks
Individual sell-side research analysts
Your own financial model

11.3 EBITDA Calculation

EBITDA = EBIT (Operating Profit) + Depreciation + Amortization

12. Spreading Multiples: The Art of Calculation and Display

Spreading multiples involves calculating and displaying key trading multiples in an easy-to-read format, typically in a spreadsheet. This allows for easy comparison across your peer universe.

The Comps table should include Mean, Median, Min, and Max statistics for each metric to provide a valuation range.

13. Valuing the Target Company: Applying the Multiples

The final step is to use the calculated multiples of the peer universe to determine the valuation of the target company.

13.1 Example Valuation Scenario

Consider a scenario where Company F has an estimated EPS of $1.50 in 2012. Using the median Comps set trading at 12.4x 2012E Earnings Per Share:

12.4 × $1.50 = $18.60 (P/E multiples give us Market Value Per Share).

Now, suppose Company F has an estimated EBITDA of $77 million in 2012. The Comps set trades at 5.4x 2012E EBITDA:

5.4 × $77 million = $415.8 million (Enterprise Value).
Subtract Net Debt: $415.8 million – ($417 million – $422 million) = $420.8 million (Market Capitalization).
Divide by Shares Outstanding: $420.8 million ÷ 30.2 million = $13.93.

13.2 Valuation Conclusion

Based on the comparable company analysis, Comp F is worth between $13.93 and $18.60 based on 2012E P/E and EBITDA multiples of public competitors.

14. The Importance of Diluted Shares Outstanding

When performing comparable company analysis, it’s essential to use diluted shares outstanding rather than basic shares outstanding. Diluted shares include the potential dilution from stock options, warrants, and convertible securities. Using basic shares can underestimate a company’s market capitalization, leading to skewed valuation multiples.

14.1 How Diluted Shares Impact Valuation

Consider two companies, A and B, in the same industry.

Company A has 10 million basic shares outstanding and 1 million stock options outstanding. Its current stock price is $50.
Company B has 10 million basic shares outstanding and no stock options. Its current stock price is also $50.

If we use basic shares, both companies would have a market capitalization of $500 million (10 million shares x $50). However, if we use diluted shares for Company A, its market capitalization would be higher because it accounts for the potential dilution from the stock options.

14.2 Calculating Diluted Shares Outstanding

The treasury stock method is commonly used to calculate diluted shares outstanding. This method assumes that stock options are exercised, and the proceeds are used to repurchase shares at the current market price.

Calculate the proceeds from stock option exercises:
- Number of stock options x Exercise price
Calculate the number of shares that can be repurchased:
- Proceeds from stock option exercises / Current market price
Calculate the net increase in shares outstanding:
- Number of stock options – Number of shares repurchased

In Company A’s case, let’s assume the stock options have an exercise price of $40.

Calculate the proceeds from stock option exercises:
- 1 million stock options x $40 = $40 million
Calculate the number of shares that can be repurchased:
- $40 million / $50 = 800,000 shares
Calculate the net increase in shares outstanding:
- 1 million stock options – 800,000 shares = 200,000 shares

Therefore, Company A’s diluted shares outstanding would be 10.2 million (10 million basic shares + 200,000 net increase).

14.3 Impact on Valuation Multiples

Using diluted shares results in a higher market capitalization for Company A:

$50 x 10.2 million = $510 million

This, in turn, affects valuation multiples like P/E ratio. If both companies have earnings of $50 million, the P/E ratio would be:

Company A (using basic shares):
- $500 million / $50 million = 10x
Company A (using diluted shares):
- $510 million / $50 million = 10.2x
Company B (using basic shares):
- $500 million / $50 million = 10x

As you can see, using diluted shares provides a more accurate representation of Company A’s valuation, which is slightly higher due to the potential dilution from its stock options.

15. Real-World Examples and Case Studies

Let’s explore a few real-world examples and case studies to illustrate the importance of using diluted shares in comparable valuation.

15.1 Case Study 1: Technology Company with Extensive Stock Options

A technology company, TechCo, has a significant number of outstanding stock options granted to employees. When performing a comparable valuation, analysts must carefully consider the impact of these options on the company’s market capitalization.

Basic shares outstanding: 50 million
Stock options outstanding: 10 million
Exercise price of stock options: $20
Current market price: $40

Using the treasury stock method:

Proceeds from stock option exercises: 10 million x $20 = $200 million
Shares that can be repurchased: $200 million / $40 = 5 million shares
Net increase in shares outstanding: 10 million – 5 million = 5 million shares

Diluted shares outstanding: 50 million + 5 million = 55 million

If analysts only used basic shares, the market capitalization would be:

50 million x $40 = $2 billion

However, using diluted shares provides a more accurate market capitalization:

55 million x $40 = $2.2 billion

This difference can significantly impact the company’s valuation multiples and how it compares to its peers.

15.2 Case Study 2: Biotech Company with Convertible Securities

A biotech company, BioPharm, has issued convertible securities, which could potentially dilute the company’s equity.

Basic shares outstanding: 20 million
Convertible securities outstanding: $100 million
Conversion price: $50
Current market price: $60

To calculate the potential dilution, we determine the number of shares that would be issued upon conversion:

$100 million / $50 = 2 million shares

Diluted shares outstanding: 20 million + 2 million = 22 million

If analysts only used basic shares, the market capitalization would be:

20 million x $60 = $1.2 billion

However, using diluted shares provides a more accurate market capitalization:

22 million x $60 = $1.32 billion

The impact on valuation multiples, such as the P/E ratio or EV/EBITDA, can be substantial, especially if the company’s earnings or EBITDA are relatively small.

15.3 Common Mistakes to Avoid

Ignoring stock options and convertible securities: Failing to account for potential dilution can lead to an underestimation of a company’s market capitalization and inaccurate valuation multiples.
Using incorrect assumptions for the treasury stock method: Using an incorrect exercise price or current market price can lead to an inaccurate calculation of diluted shares outstanding.
Not disclosing the use of diluted shares in valuation reports: Transparency is essential. Always disclose whether you are using basic or diluted shares and explain the impact on your valuation analysis.

By carefully considering potential dilution and using diluted shares outstanding, analysts can perform more accurate and reliable comparable valuations, leading to better investment decisions.

16. The Role of COMPARE.EDU.VN in Financial Analysis

COMPARE.EDU.VN serves as a comprehensive resource for financial analysis, providing tools and insights to navigate the complexities of valuation techniques. Here’s how it can assist:

16.1 Data Accessibility

Access to reliable and up-to-date financial data is crucial for accurate Comps analysis. COMPARE.EDU.VN offers tools to access and compare financial data from various companies, ensuring you have the necessary information to conduct a thorough analysis.

16.2 Peer Group Analysis

Identifying the right peer group is critical for effective Comps. COMPARE.EDU.VN provides features to identify and analyze comparable companies, helping you build a relevant peer universe for valuation.

16.3 Multiple Calculation Tools

Calculating valuation multiples can be time-consuming. COMPARE.EDU.VN offers tools to quickly calculate and compare key multiples, such as EV/EBITDA and P/E ratios, streamlining your valuation process.

16.4 Educational Resources

Understanding the nuances of financial analysis is essential. COMPARE.EDU.VN offers educational resources, including articles, tutorials, and case studies, to deepen your knowledge and improve your valuation skills.

17. Best Practices for Using Diluted Shares in Valuation

To ensure accuracy and reliability in your valuation analyses, follow these best practices when using diluted shares:

Always Use Diluted Shares for Valuation Purposes: Diluted shares provide a more comprehensive view of a company’s equity structure by accounting for potential dilution from stock options, warrants, and convertible securities.
Understand the Different Methods for Calculating Diluted Shares: Familiarize yourself with the treasury stock method, the if-converted method, and other relevant techniques to accurately calculate diluted shares.
Carefully Review Footnotes and Disclosures: Pay close attention to footnotes in financial statements and disclosures related to stock options, warrants, and convertible securities. These sections provide valuable information for calculating diluted shares.
Consider the Exercise Price and Conversion Price: When calculating the impact of stock options and convertible securities, consider the exercise price and conversion price relative to the current market price. Only include securities that are “in the money” (i.e., the exercise price is below the market price).
Be Consistent with Your Approach: Use the same method for calculating diluted shares across all companies in your peer group to ensure comparability.
Disclose Your Methodology: In your valuation reports, clearly disclose whether you are using basic or diluted shares and explain the methodology you used to calculate diluted shares.
Check for Anti-Dilutive Securities: Anti-dilutive securities are those that would increase EPS if converted or exercised. These securities should be excluded from the diluted shares calculation.

18. Frequently Asked Questions (FAQ)

Why is it important to use diluted shares outstanding in comparable valuation?
- Diluted shares provide a more accurate representation of a company’s equity structure by accounting for potential dilution from stock options, warrants, and convertible securities. Using basic shares can underestimate a company’s market capitalization, leading to skewed valuation multiples.
What is the treasury stock method, and how is it used to calculate diluted shares?
- The treasury stock method is a common technique for calculating diluted shares. It assumes that stock options are exercised, and the proceeds are used to repurchase shares at the current market price. The net increase in shares outstanding is then added to the basic shares to arrive at the diluted shares.
How do convertible securities impact diluted shares outstanding?
- Convertible securities, such as convertible bonds or preferred stock, can be converted into common stock. When calculating diluted shares, you need to determine the number of shares that would be issued upon conversion, assuming the securities are “in the money.”
What are anti-dilutive securities, and how should they be treated in the diluted shares calculation?
- Anti-dilutive securities are those that would increase EPS if converted or exercised. These securities should be excluded from the diluted shares calculation because they would not actually dilute the company’s equity.
Where can I find information about a company’s stock options, warrants, and convertible securities?
- Information about a company’s stock options, warrants, and convertible securities can be found in the footnotes to the financial statements and in the disclosures related to equity compensation plans.
Is it always necessary to use diluted shares outstanding, even if the impact is minimal?
- Yes, it is always best practice to use diluted shares outstanding, even if the impact is minimal. This ensures that your valuation analysis is comprehensive and accurate.
How does the use of diluted shares affect valuation multiples like P/E ratio and EV/EBITDA?
- The use of diluted shares can impact valuation multiples by increasing the company’s market capitalization. This can result in higher P/E ratios and potentially lower EV/EBITDA multiples, depending on the company’s earnings and debt levels.
Are there any situations where it would be appropriate to use basic shares outstanding instead of diluted shares?
- In general, it is always best practice to use diluted shares outstanding for valuation purposes. However, there may be some limited situations where it is acceptable to use basic shares, such as when valuing a company with no stock options, warrants, or convertible securities.
How can I ensure that I am calculating diluted shares outstanding correctly?
- To ensure that you are calculating diluted shares outstanding correctly, carefully review the company’s financial statements and disclosures, consult with a qualified financial professional, and use reliable sources of information.
Where can I find more resources and information about comparable valuation and diluted shares?
- You can find more resources and information about comparable valuation and diluted shares on financial websites like COMPARE.EDU.VN, in textbooks and academic journals, and through professional organizations such as the CFA Institute.

19. Conclusion: Making Informed Valuation Decisions

Understanding whether to use diluted shares outstanding for comparable valuation is critical for accurately assessing a company’s financial health and making informed investment decisions. By carefully considering potential dilution and following best practices, analysts can perform more reliable valuations.

Remember to leverage resources like COMPARE.EDU.VN to access data, tools, and educational content that will enhance your valuation skills and ensure your analyses are accurate and insightful.

Ready to take your financial analysis to the next level? Visit COMPARE.EDU.VN today for comprehensive tools, data, and insights that will help you make informed decisions. Whether you’re comparing investment opportunities or assessing company valuations, COMPARE.EDU.VN is your go-to resource.

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