KCSA PUBLIC RELATIONS, INVESTOR RELATIONS BLOG

The Comp Problem

Posted by on June 5, 2012

At KCSA, we often work with small, innovative companies that offer unique products or services. Many of these companies are undervalued with tremendous upside, but it can be difficult to get investors to recognize their potential. Why? Investors have nothing to compare them to.

There are many different ways to value a firm. But one of the simplest ways is to see how the financial performance of a company stacks up to its peers. Using ratios such as a price-to-earnings multiple or enterprise value-to-EBITDA multiple, investors can quickly determine if a particular stock is trading at a discount or premium as compared to its competitors.

Most importantly, they can determine whether that disparity is warranted and take advantage of it by buying or shorting the equity.

But when there are no peers, it makes it harder for investors to get a sense of how much a company is worth. It also increases the likelihood that the market may be mispricing the stock.

One way for management to make the case that investors should buy their stock is by emphasizing their ability to create shareholder value. After all, who wouldn’t want to purchase shares in a company that takes investors’ hard-earned dollars and puts them to good use?

The best way to measure shareholder value is by looking at the spread between a company’s Return on Invested Capital (ROIC) and its Weighted Average Cost of Capital (WACC).

ROIC looks at how much a company has generated in after-tax cash flow with each dollar—both debt and equity—invested. WACC looks at the returns that debt and equity investors expect. To put it another way, WACC is the opportunity cost.

When ROIC exceeds WACC, the company is creating shareholder value. When it falls below, the company is destroying value.

As valuation guru Aswath Damodaran of NYU’s Stern School of Business points out, “The value of a business can be simply stated as a function of the ‘excess returns’ that it generates from both existing and new investments.”

When communicating with potential or current investors, management should not only discuss how it has delivered shareholder value, but also walk them through future expectations.

As Michael Mauboussin, a chief investment strategist at Legg Mason Capital Management, notes in his excellent paper, companies with a mismatch between the ROIC implied by their stock price and their actual performance vastly outperformed the market.

Investor outreach takes time and diligence, especially for companies without comps. But when done correctly with the right messaging, it can yield incredible results.