Using Ebitda multiple to buy stocks
If there is a pricing multiple that values the equity of a firm, which is the price-to-earnings ratio, there is also a multiple that determines the entire worth of a firm.
This is the enterprise value-to-Ebitda ratio. This ratio is used on the belief that investors do not only pay for the residual earnings of the company but also for the cash flows of the whole business.
The enterprise value (EV) of a company is computed by simply taking the sum of the market value of its equity and net book value of its debt.
The Ebitda, on the other hand, which stands for earnings before interest, tax, depreciation and amortization, represents the “cash earnings” of the company.
Ebitda, as a broad measure of cash flows, helps determine the true earnings potential of a company by adding back its financing costs and noncash expenses.
The use of EV/Ebitda ratio as a pricing tool has been popular among market analysts and fund managers in recent years because losing companies that cannot be valued by P/E ratios can be attractively priced at the Ebitda level.
The EV/Ebitda ratio indicates the number of years that the company will need to generate cash earnings to arrive at its current enterprise value.
Similar to the P/E ratio, the lower the EV/Ebitda ratio, the better it is supposed to be.
While comparing ratios may seem simple and easy to understand, buying stocks based on this approach may not be advisable.
For one, Ebitda does not consider the financial risk of the company by including interest expense as part of its earnings.
Ebitda also fails to account for the annual capital expenditures and working capital requirements of the company, thereby overstating its free cash flows.
So what do we really mean by EV/Ebitda ratio?
Remember that the value of an enterprise is a function of risk, cash flows and growth.
Based on this concept, the intrinsic EV/Ebitda multiple can be calculated by simply taking the free cash flow percentage of Ebitda before it is divided by the risk factor.
The risk factor is the difference between the cost of capital of the company and its expected growth rate.
For example, Globe Telecom’s free cash flow as percentage of its Ebitda based on last year’s financials is estimated to be about 21.6 percent.
This will then be divided by its risk factor of 1.8 percent to derive the target EV/Ebitda multiple of 11.7 times, which makes the current share price look undervalued at only 6.4 times.
The risk factor is computed by taking the difference between the stock’s cost of capital of 7.8 percent and long-term growth rate of 6 percent.
Following this model, we can see that the ideal EV/Ebitda ratio of a stock goes up when its free cash flow increases as percentage of Ebitda or its cost of capital decreases.
In fact, both free cash flows and cost of capital have significant 22-percent correlation with EV/Ebitda ratio.
The free cash flows of a company, which can be calculated by taking the operating cash flows minus its capital expenditures, can be a strong determinant of a stock’s intrinsic EV/Ebitda ratio.
Any company whether profitable or not can produce positive Ebitda but not everyone can generate consistent free cash flows.
Some companies may not have enough operating cash flows to fund their capital expenditures. Normally, this is what growth companies experience when it has to source external financing to expand.
Other companies do not even have positive operating cash flows in the first place because the business could not finance its working capital requirements.
Using EV/Ebitda multiples goes beyond simple ratio comparison. You need to take time to understand the fundamentals behind it.
How much free cash flow can the company produce out of its Ebitda? How does the current interest rate outlook and volatility of the stock affect the company’s cost of capital?
These are some questions that can help you assess in finding quality stocks based on EV/Ebitda multiple perspective.
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 75th batch of RFP Program this March 2019. To register, e-mail [email protected] or text <name><e-mail> <RFP> at 0917-9689774
