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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.