What Does EV/EBITDA Multiple Mean?

Lessons/Primers

Brief History of Valuation and the Emergence of EBITDA

  • One hundred years ago, investors valued stocks on metrics such as dividend yield, P/E multiple, and P/B value multiple
  • The value of a stock is the present value of future free cash flows. This is what you learned if you studied finance in school
  • But there has always been a gap between theory and practice. DCF model, while analytically sound, demands a number of judgments. Most practitioners avoid a DCF model altogether and instead use shorthands in the form of multiples
  • It is crucial to acknowledge that multiples are not valuation but rather a summary of the valuation process
  • Will Thorndike, an investor and the author of The Outsiders, credits John Malone with introducing the term EBITDA. Malone is a media mogul who made his fortune with media investments
  • Early enthusiasts cited three reasons to use EBITDA rather than a more traditional metric
    • It is a broad measure of cash flow and indicates the capacity to invest and service debt
    • It can be relevant for companies losing money because EBITDA is often positive even when earnings are negative
    • EBITDA appears more applicable for companies that seek to minimize taxes by adding debt, as interest expense is tax deductible
  • Partly reflecting these reasons, EV/EBITDA became the main metric investors used to evaluate leveraged buyouts in the 1980s and it remains the primary way to value PE deals

Definition of Terms

  • Enterprise value is the value of the core operations less nonoperating assets, such as excess cash and nonconsolidated subsidiaries; also equal to short- and long-term debt, debt equivalents, and other claims, less excess cash and nonoperating assets, plus equity value
  • EBITDA is operating profit plus depreciation and amortization expense; EBITDA does not reflect interest expense, taxes, or investments required to maintain or grow the business, including changes in net working capital, capital expenditures, and acquisitions
  • Because EBITDA can be distributed to all claimholders, it is appropriate to compare it to enterprise value

Limitations of EBITDA

  • Warren Buffett had this to say about EBITDA at Berkshire’s annual shareholder meeting in 2003:
    • “Any management that doesn’t regard depreciation as an expense is living in a dream world. But of course, they are encouraged to do that by investment bankers who talk to them about EV/EBITDA. And certain people have built fortunes on misleading investors by convincing them that EBITDA was a big deal. I get these people that want to send me books with EBITDA in it. And I just tell ‘em, “I’ll look at that figure when you tell me you’ll make all of the future capital expenditures for me”
  • Seth Klarman:
    • “It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. EBIT did not accurately measure the cash flow from a company’s ongoing income stream. Adding back 100% of D&A to arrive at EBITDA rendered it even less meaningful. Those who used EBITDA as a cash flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out”
  • There are at least 3 pitfalls to using EV/EBITDA
    • There is not a proper reckoning for the investment needs of the business. The potential danger in using EBITDA is that it understates the capital intensity of the business. Working capital changes and acquisitions can also be vital
    • Multiples do not explicitly reflect risk. Operating leverage, the % change in operating profit as a function of the % change in sales, is a suitable measure of business risk
    • Two companies with the same EBITDA and capital structures may pay taxes at dissimilar rates
    • Essentially, the shortcomings of EBITDA reflect the items that reconcile EBITDA to free cash flow

Theory to Practice – Part I

  • Value of the firm = Steady-state value + Future value creation
  • Over the past 60 years, roughly 2/3 of the value of the S&P 500 price was attributable to steady-state value
  • The important point is that future value creation is based on three elements: finding projects that generate a positive spread between ROIC and WACC, how much you can invest in those projects, and how long you can find those projects in a competitive world
  • If a company earns exactly its cost of capital, growth doesn’t matter. The company is on an economic treadmill, so speeding up or slowing down doesn’t matter. All we can count on is the steady-state value
  • When returns are above the cost of capital, growth becomes extremely valuable. For example, when the ROIC is 24%, going from 6% to 10% growth lifts the warranted P/E ratio from 19 to 26
  • If a company is investing at a rate below the cost of capital, growth is bad. The faster it grows, the more wealth it destroys. You see this when a company announces an acquisition that adds to EPS but reduces market cap (the market renders its judgment on the deal’s economic value)

Theory to Practice – Part II

  • In order to go from theory to the relevant EV/EBITDA multiples, we need to discuss 3 interrelated topics: capital intensity, ROIC, and leverage
  • There are 3 major forms of investment that show up on the balance sheet: changes in net working capital, capital expenditures minus depreciation and acquisitions minus divestitures
  • Overall, net working capital does not demand a lot of investment. It is useful to analyze a company’s cash conversion cycle, a calculation of how long it takes a company to collect on the sale of inventory. Good working capital management is associated with high returns on invested capital
  • Capital expenditures are a significant investment over time, second only to acquisitions in total dollars spent. Analysts commonly use depreciation as a proxy for maintenance capital expenditures and fail to consider the investment necessary to support value-creating growth. Capex has averaged about 1.5x depreciation for the top 1,500 industrial companies in the US over the past 4 decades
  • Acquisitions are by far the largest source of investment. Investors extrapolate a historical EBITDA growth rate that is in part the result of acquisitions but don’t consider appropriate investments in their forecasts. As a result, they underestimate the capital required to achieve that growth
  • For some sectors, including consumer staples and IT, EBIT is about ¾ of EBITDA. For other sectors, such as telecom and energy, DA is the larger component of EBITDA – use of EBITDA creates a risk of understating capital intensity for companies with high EBITDA depreciation factors
  • Return on incremental invested capital compares the change in NOPAT in a given year to the investments made in the prior year. When ROIIC is high, a company can achieve its growth targets while investing a modest amount
  • We should expect that industries with low EBITDA depreciation factors have higher ROICs than industries with high EBITDA depreciation factors. It is generally very difficult to generate high ROICs in capital intensive industries
  • Value of income shielded by interest expense is in the cost of capital. The central point is that leverage affects the WACC and not the ROIC
  • Pecking order theory of capital structure says that companies access capital first through internally generated cash, next by raising debt, and finally by raising equity. Capital intensive industries tend to use more debt financing than capital light industries because they cannot fund their growth solely through internally generated cash
  • High ROIC businesses can increase leverage but low ROIC businesses cannot readily delever. Businesses with high EBITDA depreciation factors tend to have more debt than those with low factors, but the correlation is not as strong as it is for ROIC
  • Companies with low EBITDA depreciation factors get higher multiples than companies with high EBITDA depreciation factors holding other value drivers equal
  • Growth doesn’t matter if your ROIIC is equal to the cost of capital, and growth amplifies the good when returns are attractive and amplifies the bad when they are unattractive

Empirical Results

  • Based on top 1,500 industrial companies in the US:
    • High ROIC and fast growing companies have the highest median EV/EBITDA multiples at 13.3x
    • High ROIC and slow growth at 11.4x
    • Low ROIC and fast growth at 8.7x
    • Low ROIC and slow growth at 8.4x

P/E vs. EV/EBITDA

  • Correlation between P/E and EV/EBITDA multiples is high (r=.79) for a large sample of companies
  • Core drivers of all multiples are incremental ROIC and growth. Two companies with the same prospects for ROIC and growth can have different relationships between P/E and EV/EBITDA because of dissimilar capital structures, different tax rates, and reckoning for unconsolidated businesses
  • Company’s capital structure can also affect the P/E multiple. Consider the simple case of a debt-financed share buyback program:
    • EPS impact of the buyback is a function of the P/E multiple and the after-tax cost of new debt
    • When the inverse of the P/E, E/P, is higher than the after-tax interest expense, a buyback adds to EPS. Assuming no change in price, this lowers the P/E
  • Lower tax rates increase EV and earnings but have no effect on EBITDA
  • Some companies have unconsolidated businesses or cross holdings that may factor into a calculation or EV but can distort earnings or EBITDA. Make sure you are looking at the operations on a consistent basis

Recommendations for Action

  • Most analysts use a multiple to assign a price to a company. Aswath Damodaran, a professor of finance at the Stern School of Business, offers the following:
    • “There’s nothing wrong with pricing. But it’s not valuation. Valuation is about digging through a business, understanding the business, understanding its cash flows, growth, and risk, and then trying to attach a number to a business based on its value as a business. Most people don’t do that. It’s not their job. They price companies. So the biggest mistake in valuation is mistaking pricing for valuation”
  • 5 ideas to bear in mind:
    • Evidence shows that buying a stock at a premium to its warranted multiple leads to poor excess returns and buying at a discount leads to attractive excess returns. Dan Rasmussen, founder and PM of Verdad Advisers, highlights analysis that suggests more than 50% of PE deals done at an EV/EBITDA multiple of 10x or higher lost money, and that for every dollar put into these deals investors got only a tad more than a dollar out. There is nothing magical about 10x. The essential point is businesses have different warranted multiples that are important to understand as you buy and sell their securities
    • Use of various valuation approaches can guide you toward a central tendency of value. Research in the forecasting literature shows that combining forecasts derived from different methods can reduce error and yield more accurate predictions
    • Before applying an EV/EBITDA multiple, be sure to consider the key drivers of value
    • Vocal critics of EBITDA may be overstating their case, but the risk of underestimating the capital required to grow is real. Make sure you consider carefully what capital needs a company truly has to make sure that cash flow projections are not illusory
    • If you use EBITDA as the terminal value in a DCF model, use the average multiple over a cycle. You may introduce a substantial error if you rely on end-of-period economic assumptions

BlueMountain Investment Research, September 2018

Image Source: Markis Capital

Advertisements