Recently, the Wall Street Journal wrote an article, “Stocks Are at Records, but Are They Expensive? These Models Have an Answer,” that discussed five common metrics for valuing the stock market. Three of these ratios, price/earnings, price/book value and PE/growth, can also be readily used for valuing individual stocks. With some adjustments to normalize a company’s earnings power across a business cycle, the fourth metric, the cyclically adjusted price/earnings multiple, could also be used.
For individual stocks, some metrics are better than others. We recently wrote about the flaws of the PE/Growth multiple here.
The EV/EBITDA metric wasn’t mentioned in the Wall Street Journal article but is one of the most widely used valuation measures among institutional investors such as mutual fund and hedge fund managers. What is this metric and why is it so popular?
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Like most metrics, the EV/EBITDA multiple compares the price of something to that thing’s earnings. The price/earnings multiple is simply the price of a share divided by the earnings per share. If we want to buy the entire company, we would buy all of the shares, which would add up to the company’s market capitalization. We would then get the entire company’s net income. The deal could be valued using the price/earnings multiple, in this case by comparing all of the company’s equity divided by all of its earnings.
Since most companies have debt and cash, buying the entire company means taking on the responsibility to pay the debt yet also the opportunity to pocket its cash. You can think of debt financing as a substitute for equity financing and cash as an offset to the debt. The EV/EBITDA multiple expands upon the P/E multiple to factor in the debt and cash.
To get the “EV” part of the multiple, we simply add total debt, and subtract cash, to the market capitalization. The term “enterprise value” is a buzzword for “business value,” or what the entire business is worth. If the company had no debt and no cash, enterprise value and market capitalization would be the same.
If we buy the entire business, we gain complete control over what to do with its operations. We might, say, decide to make the operations more efficient, which would boost operating profits. We might decide to spend more on research to help spur growth. In essence, we are buying that company’s current and future operating profits. Operating profit, also called earnings before interest and taxes, or EBIT, gets us most of the denominator of our EV/EBITDA valuation multiple.
We need to make one other adjustment to operating profits. Depreciation and amortization are accounting entries that reflect prior years’ capital spending. But our focus is on cash profits rather than accounting profits. So, we add back depreciation and amortization to our EBIT number to get EBITDA, or earnings before interest, taxes, depreciation and amortization. Another term for this is “cash operating profits.”
So, EV/EBITDA is simply the value of the entire business divided by the cash operating profits. It shows us how much we are paying compared to how much in earnings we are getting. This metric gives us a clearer picture of a company’s valuation, regardless of how much is financed by equity and how much is financed by debt.
This metric has a few advantages over P/E and other valuation measures. First, it allows for more accurate comparisons of different companies. As an example, Post Holdings (POST) and Conagra (CAG) trade at very different P/E multiples. Post Holdings appears to be much more expensive, at nearly 19x, compared to Conagra at about 11x. However, on an EV/EBITDA basis, both trade at essentially the same 9.5x EV/EBITDA multiple. These two slow-growing food companies are quite similar – and the EV/EBITDA multiple captures this similarity much better than the P/E multiple.
Another advantage is due to the rise of private equity. Private equity firms today have enough money to acquire most public companies. And, since these investors take control of the cash operating profits, they value their targets based on the entire business. Thinking like a buyer of an entire company helps all investors better understand the value of public companies.
There are many ways to value stocks. By adding the EV/EBITDA multiple to their toolkit, value-oriented investors can better understand which companies are true bargains.
As value and contrarian investing specialists, we focus on companies that have “the right stuff.” We do all the extensive idea searching and analysis to help you benefit from out-of-favor stocks. Our capabilities save you time while boosting your chances of profitable investing.
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