Sep 6, 2014 Investment Education: Adding EV/EBITDA to Your Relative Value Toolkit
Adding EV/EBITDA to Your Relative Value Toolkit
In Why Stocks Go Up and Down, we discussed various relative value models used by investors. With relative value models, the company being analyzed is compared to other, similar companies for the purpose of identifying under- and overvalued securities. When it comes to relative valuation, the price-to-earnings (P/E) ratio is undoubtedly the most common method used, but no one method works for every stock. Each company is unique, and the dynamics of each industry require specific valuation approaches. As Geoff Gannon puts it, limiting yourself to a single approach would be “like gouging out one of your eyes. True, 90% of the time you only need one eye, but sometimes it helps to have depth perception. And for that, two eyes are better than one.” For investors who want to add depth to their P/E-based relative value approach, enterprise value-to-EBITDA (EV/EBITDA) is increasingly being viewed as the “go-to” multiple.
P/E is simply the company’s market value divided by net income. The most important indicator of intrinsic value, however, is cash flow. EBITDA is a better proxy for cash flow than net income, and the fundamental drivers of the EBITDA multiple are the same as those of free cash flow: return on invested capital, growth, and cost of capital. As Aswath Damodaran notes in The Little Book of Valuation, “The Value of a firm is a function of three variables – its capacity to generate cash flows, the expected growth in these cash flows, and the uncertainty associated with these cash flows. Firms with higher growth rates, less risk, and greater cash flow generating potential should trade at higher multiples than firms with lower growth, higher risk, and less cash flow potential.” [i] Thus, as noted in Valuation: Measuring and Managing the Value of Companies, “integrating the EBITDA multiple into your valuation will provide a useful check of your DCF forecasts and offer critical insights into what drives value in a given industry” not available through the P/E ratio. [ii]
Since the P/E ratio looks only at the current market price of the company’s shares, a company with debt can look deceptively cheap on a P/E basis. For example, if an all-equity company with a P/E ratio of 15x decides to raise its debt-to-value to 25% ratio by borrowing at a 4% fixed rate, the P/E will fall to 13.2x assuming no taxes. Likewise, a cash rich company with no debt can look expensive because the P/E ratio does not capture the cash on the company’s balance sheet. The EV/EBITDA ratio, on the other hand, captures both large cash and debt positions held by a company. That is because enterprise value is the price an investor would pay for the entire business, not just the equity component. It is calculated as the sum of market cap (i.e., price per share x shares outstanding) and net debt (i.e., debt – cash).
EV/EBITDA also allows investors to compare the operating earnings of different companies without concern for differences in depreciation techniques, interest costs, or tax rates. Often times, companies being compared have different depreciation policies, which argues for ignoring the effects of depreciation and amortization in a relative value comparison. In addition, depreciation and amortization are non-cash charges that should be ignored. Interest expense is excluded in the EBITDA multiple because it is the result of management’s financing – rather than operating – decisions and the ever-changing interest rate environment. Likewise, pre-tax operating earnings provides greater comparability due to the different accounting policies adopted for deferred tax and variation in effective tax rates, which are a consequence of geographic mix (i.e., where the company sells its products and services), year-to-year tax law changes, and other factors that can have a distorting effect. Thus, since EBITDA looks at cash flow before depreciation, interest expense, and taxes are considered, it puts companies on a more directly comparable basis…a key ingredient for a relative value analysis.
Empirical evidence supports the use of the EBITDA multiple. A study published by Wesley Gray and Jack Vogel entitled Analyzing Valuation Measures: A Performance Horse Race Over the Past 40 Years demonstrated the efficacy of EV/EBITDA.[iii] The study evaluated the performance of stocks from July 1, 1971 to December 31, 2010. In equally-weighted portfolios that were rebalanced annually, the most attractively valued quintile of P/E stocks returned 15.23% per year. The most attractively valued quintile of stocks based on EV/EBITDA returned 17.66% per year. The superior efficacy of EV/EBITDA over the P/E ratio was also illustrated by the spread between the highest and lowest valued quintiles. The spread for the EV/EBITDA ratio was 9.69%; in other words, the most undervalued quintile outperformed the most overvalued quintile by nearly 10%. The comparable spread for the P/E ratio was 5.82%. James O’Shaughnessy’s published similar results in his book, What Works on Wall Street, 4th Edition. In the book, he evaluates the efficacy of EV/EBITDA, P/E, and other relative value tools. O’Shaughnessy notes, “EV/EBITDA outperformed every other valuation strategy, including P/E.” [iv]
While EV/EBITDA can be a valuable addition to investors’ relative value toolkit for the reasons discussed above, it is not infallible. It is affected by the capital intensity of a business. Investors should be cognizant of the proportion of EBITDA that will be used to buy or replace fixed assets. If the capital intensity of the firms being analyzed differs significantly, an EBITDA multiple comparison can lead to misleading results. This typically isn’t a problem since the company is being compared against its peers. It can, however, create an issue when one company rents and another buys its assets unless appropriate adjustments are made. For those investors who want to add EV/EBITDA to their relative value toolkit, the multiple should also be adjusted for non-operating items such as operating leases (which lead to artificially low enterprise value), pension expense (ditto), and differences in tax rates.[v] Often times, the effective tax rate of companies in the same industry are comparable, but if a company’s tax rate is sustainably lower (higher) than peers, it will likely increase (reduce) the EBITDA multiple investors will be willing to pay. In addition, forward – not trailing – EBITDA multiples should be employed. In a Journal of Accounting Research article entitled Equity Valuation Using Multiples (2002), Jing Liu, Doron Nissim, and Jacob Thomas demonstrated that forward-looking multiples increase predictive accuracy and improve multiple consistency within an industry.
In conclusion, oversimplification of valuation can lead to bad investment decisions. While the P/E ratio is the most commonly used valuation method, a thorough relative value analysis should integrate multiple methods, including EV/EBITDA. The EBITDA multiple has the same fundamental value drivers – return on invested capital and growth – as a DCF-derived valuation, and it standardizes companies with different depreciation methods, interest payments, and tax rates. When using EV/EBITDA, investors should use forecasted operating earnings adjusted for operating leases and pension expense and make comparisons to companies with similar profiles.
References
[i] Damodaran, Aswath. The Little Book of Valuation: How to Value a Company, Pick a Stock, and Profit. Hoboken: Wiley & Sons, 2011.
[ii] McKinsey & Co. Valuation: Measuring and Managing the Value of Companies, 4th Edition. Hoboken: Wiley & Sons, 2010
[iii] Gray, Wesley and Jack Vogel. Analyzing Valuation Measures: A Performance Horse Race Over the Past 40 Years. The Journal of Portfolio Management Vol. 39: 112-121
[iv] O’Shaughnessy, James. What Works on Wall Street, 4th Edition. New York: McGraw-Hill, 2012.
[v] For more details, see Valuation: Measuring and Managing the Value of Companies, 4th Edition.
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