Turnaround Investing Blog

George Putnam, one of the country's leading turnaround and distressed investing professionals, shares his timely insight on the economy and turnaround investing opportunities.

EV/EBITDA: What Is It & Why Are We Using It More?

Excerpted from the September 2017 Issue

In reading recent editions of The Turnaround Letter, you have probably noticed that we are increasingly using EV/EBITDA as a valuation measure, rather than the better-known price/earnings multiple. We thought it might be useful to describe this measure and why we like it.

Like the price/earnings multiple, the EV/EBITDA multiple compares a stock’s price to some measure of earnings, to gauge what you are paying for those earnings. EBITDA stands for “Earnings Before Interest, Taxes, Depreciation and Amortization.” This isolates the cash operating profits – the heart of the business – from everything else, such as interest costs, taxes and non-cash costs. EBITDA also removes depreciation and amortization (D&A) because they are non-cash charges that are based on accounting rules relating to past historical capital spending, and they may not bear any relationship to future earning power. By excluding all of these items, EBITDA provides a relatively pure measure of the company’s ability to generate cash from its operations. 

The Enterprise Value (or “EV”) includes the value of the company’s stock (or market capitalization), plus preferred stock, plus its debt and less its cash balance. As such, it is the value of all of the company’s capital regardless of whether it is equity or debt. Cash is considered an offset to the debt, as the cash could be used to repay debt. Putting these two parts together, we get the value of the entire company as a multiple of its cash operating profits. 

By way of contrast, the “earnings” side of the P/E ratio can be clouded by a number of non-cash or historical items that make it hard to evaluate the true value of a business going forward. Also, the “price” side of P/E includes only the value of a company’s stock and ignores the debt and cash on its balance sheet.

Why do we often prefer EBITDA as a measure of value? First, rather than focusing on accounting profits, it focuses on cash profits, which are the ultimate driver of company value. As such, it is widely used for private equity and merger & acquisition transactions, which increasingly drive stock market valuations. Also, the metric makes it easier to compare similar companies with different capital structures – especially relevant today when interest costs are so low that earnings are barely penalized when companies take on heavy debt loads. EBITDA can be particularly useful in evaluating a turnaround stock because the “earnings” that appear on the company’s bottom line may be weighed down by backward-looking restructuring charges or other non-cash items even though the business is again generating a healthy cash flow. 

Determining what EV/EBITDA multiple makes a stock attractive, just as with a P/E multiple, is admittedly a form of art. Some very general rules of thumb that we use: a business that has reasonably stable profits and average capital spending requirements might have an EV/EBITDA multiple of 5-8x. Weaker businesses may warrant multiples in the 3-4x range. Multiples above 11x are on the expensive side and are generally reserved for companies with strong growth, wide margins, low capital spending needs or some other highly favorable characteristics.

The September 2017 issue of The Turnaround Letter details four companies that have low EV/EBITDA multiples but noticeably higher P/E multiples that might be worth a closer look for your portfolio. Learn more.

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A Closer Look At Two Activist Campaigns

Watch to see if ADP’s CEO Carlos Rodriguez inadvertently helps Pershing, and his aggressive and sometimes personal stance against Ackman could backfire. Overall, because of the stock’s strong returns and Ackman’s weak credibility, we would give this activist campaign a low chance of making ADP a successful turnaround investment. For turnaround investors, the Trian campaign appears to have a win-win opportunity for investors--either Peltz joins the board and learns enough to re-invigorate P&G, or loses and management must either execute (boosting earnings and the shares) or they will face a more drastic proxy campaign with higher odds of success down the road. We think the P&G campaign could turn out well for shareholders.  Read More.

Warrants: A Solid Investment Opportunity

Warrants provide a valuable tool for the savvy investor. When selected and implemented well, they can be a smart addition to a diversified investor’s portfolio. Like options, warrants are not equity. They only convey the right to buy equity. As such, neither holder is entitled to dividend rights, pre-emptive rights, proxy voting or any share of any liquidation.

 

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Warrants' return potential can be very high, but they also carry significant risks. Learn what they are, how they work, strategies to minimize risk and find profit with warrants.

Here's Why You Should Invest in Asset Managers

 

stock market advicex

 

This Forbes article cites a recent MoneyShow write-up that recommends investors take advantage of the strong stock market and potential interest rate hike by "putting some of your investment assets into the shares of asset management stocks."

 

The article praises The Turnaround Letter's OAK purchase recommendation and quotes George Putnam: "As the corporate debt binge that we’ve experienced since 2009 comes to an end, Oaktree will benefit from a growing number of restructurings and bankruptcies."  

 

Learn more about Putnam's investing success with turnaround stocks.