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Comparable Asset Analysis
Course Section 4 - Lesson 4
Any time you make a purchase, especially if it's a big dollar item, you will inevitably go through a process of comparing the thing you want to the other alternatives available.
If you're thinking about buying a car, say a Toyota Camry, then you'll probably also look at a Honda Accord, or a Chevy Malibu, or even a Ford Fusion. In your mind, you'll be comparing the features of each model and weighing those against the price of each sedan. What you wouldn't do is suddenly throw a Porche 911 into the comparison set. It simply doesn't provide any relevant data for the decision you're trying to make.
In day-to-day life, we humans seem to be pretty good at identifying comparable assets to help us gauge value when we buy the things we want. That seemingly innate ability we have all but disappears when we start looking at financial assets.
When we see a stock trading at 20 times earnings, we suddenly feel the need to compare that company against every other stock on the market to figure out if it's expensive or not. This is not an effective strategy.
Value a Company Relative to its Peers
Just as we would do with the Camry we are thinking of buying; we need to benchmark potential investments against a lineup of peer companies. Throughout this course, we have been evaluating Texas Roadhouse. We've established that it is a solid company. We're now to a point we can begin thinking about whether or not we want to make a purchase.
In making this decision, it would not help us to compare Texas Roadhouse's market valuation to Walmart or Google to find out if it's priced attractively. Those companies run businesses that are too different from Texas Roadhouse to generate meaningful insights.
Instead, we should stick to the casual dining industry when trying to figure out if the stock is priced attractively. From our earlier lessons, you'll remember that we defined the casual dining industry as:
Texas Roadhouse, Inc. (TXRH)
Cracker Barrel Old Country Store, Inc. (CBRL)
Chuy's Holdings, Inc. (CHUY)
Brinker International, Inc. (EAT)
Bloomin' Brands, Inc. (BLMN)
The Cheesecake Factory Incorporated (CAKE)
Dave & Buster's Entertainment, Inc. (PLAY)
Red Robin Gourmet Burgers, Inc. (RRGB)
Denny's Corporation (DENN)
Darden Restaurants, Inc. (DRI)
By looking at how the market currently values all of these companies, we can get a sense of whether or not our target company is priced attractively. To do so, we can leverage the valuation ratios that we learned about in the last lesson.
To speed up data collection, I'm pulling the ratios for each company directly from Tikr.com into an excel spreadsheet.
Comparing Casual Dining Competitors
Now that we've aggregated the necessary data for Texas Roadhouse and its peers, we can begin to dissect whether or not the company is an attractive purchase right now.
The table above is informative, but it's hard to make heads or tails of in its current format. To make things easier to digest, I'll convert the table into three separate charts: one for EV / Revenue, one for EV / EBITDA, and one for EV / EBIT.
For each of the above charts, the appropriate multiple for each restaurant is graphed against its peers. To aid in the interpretation of graphs, I've split the background of each graph into 3 equally-sized sections. The green section represents the lowest, most attractive valuations, yellow represents the middle of the road valuations, and red represents the highest valuations.
A lot is going on in the three charts, but the first thing I want to do is establish which of the charts offers the best information for us as investors.
If we look at the first chart, EV / Revenue, we see a lot of variance across the companies. Some stocks trade at around 1x revenue (BLMN & RRGB), while others trade at ~4x revenue (DENN & PLAY). That's a huge gap that you shouldn't expect to see if EV / Revenue was a good proxy for value in the industry. Indeed, if we look closer at the underlying businesses, we would see that the most expensive companies (DENN & PLAY) are also the companies with the highest operating margins, around 13%, and the least expensive companies (RRGB & BLMN) are those with the lowest operating margins, around 3-5%. This gives us a clue that would should take a step down the income statement and instead look at multiples based on EBITDA.
Looking at the EV / EBITDA multiples, we still see some variance, but generally, all of the companies are within about 30% of the industry average. This is a strong indication that we've found an appropriate multiple for the industry, and we don't have to move any further down the income statement.
If we were to continue down to an EV / EBIT multiple, we once again see the deviation in multiples across companies widen out. This is explained by the fact that EBIT deducts depreciation, a massive expense for some of the companies, like Darden (DRI) and Texas Roadhouse (TXRH), while having little effect on others like (DENN). This further confirms that we have indeed found the correct multiple to focus on with EV / EBITDA.
Interpreting Casual Dining Valuations
Now that we are confident that we are looking at an appropriate multiple for the industry let's assess how these companies are priced. I'll begin re-organizing the EV / EBITDA chart we looked at a moment ago by lowest to highest multiple.
Immediately it's evident that casual dining companies are falling into three pricing tiers:
the questionably cheap stocks (BLMN & EAT)
the average stocks (CBRL, DRI, CAKE, RRGB, and TXRH), and
the expensive stocks (PLAY, CHUY, and DENN)
Interestingly, when we were evaluating Texas Roadhouse's business earlier in the course, it ranked among the strongest in the category. Yet, here we see that the market is valuing the stock in line with its much more average peers.
Let's take a look at a chart we built back in section 4 - lesson 2 comparing the growth and margins of companies in the casual dining industry. Only this time, let's also include the EV / EBITDA ratio for each of the companies.
Texas Roadhouse has been among the fastest-growing casual dining restaurants in the peer group, with more room to grow in the future. On top of that, as we discussed earlier in the course, we have reason to suspect that TXRH could experience margin expansion as the brand continues to mature. It does not make sense that Texas Roadhouse is trading at levels consistent with much weaker casual dining operators.
A Great Company at an Attractive Price
It appears that we've identified a great company, in an industry we believe in, that is trading at an attractive price. All of the pieces have come together into an investable opportunity.
In the next and final lesson of section four, we are going to define our investment thesis for Texas Roadhouse. This will involve stating our beliefs about the company and committing those beliefs to paper. This is an important step in the process that will allow us to make sure that this investment stays on track as we move forward through time.