Using the EV/EBITDA Ratio in a Stock Analysis

The market has continued to deliver non-stop action as we wrap up the second month of 2016.

The number of triple digit gains/losses for the Dow Jones average, increase in overall volatility, and almost daily large swings in individual stocks has provided opportunity and excitement for a lot of us.

35% gains in KORS, 25% gains in DECK, 12% gains in LOPE, and multiple gains in oil stocks have already happened for many of you in the first couple months, during a stock market that has been filled with fear, pessimism, and falling prices.

The big question from here is: where is the market headed?

The cover of Barron’s this week says the S&P 500 is going to make new highs beyond 2,250 by year-end. Then again, flipping forward just a few pages in the same issue reveals analysts stating the S&P 500 will drop to 1,700 or lower before it rebounds.

You can find the same uncertain results by looking at just about any financial publication or talking to different analysts and advisors.

What does it all mean?

It means that we simply don’t know, Barron’s doesn’t know, your financial advisor doesn’t know, and the big banks on Wall Street don’t know where the market is going to go from here. It’s impossible to predict where the aggregate of all the companies in the United States are financially headed, as well as what kind of economic data will be revealed in the coming months about US economic strength/weakness. There are too many moving parts for any one to say they know, with any degree of certainty, where the market as a whole is going to go from here.

And ultimately…it doesn’t matter where it’s headed.

Why?

 

Two Schools of Thought

The traditional financial advice follows two main themes:

  1. You can’t predict where the market is going
  2. The market historically skews upward

Following these two themes, most financial professionals come to the conclusion that you need to continue to plow money into diversified equities (usually mutual funds) with dollars from each paycheck.

Given that information, it makes pretty good sense that it doesn’t matter where the market goes from here (short-term), as long as you continue diligently contributing money in each month. Historically speaking, doing that will get you only an average rate of return. That’s the advice of many financial professionals.

And that’s true—on average, the United States stock market has yielded around a 6% return after fees.

So that’s one option. And it’s not bad. But at best, it will give you mediocre results.

However, this assumes you avoid poor timing or just plain bad luck.

Investing in the peaks of 2000 and 2007 wouldn’t have been too good. Buying the S&P 500 at the peak of 2000 would have yielded a 1.38% annualized return (plus dividends) on your money over this nearly 16-year period. And there have been multiple stretches of around 20 years where the market has not provided any real return beyond inflation. Investing at inopportune times would have completely altered your retirement scenario. This happened to many Americans at just the wrong point in their lives—just as they were getting ready to retire.

And what about if the US goes into a Japan-type situation with equities? Japan’s Nikkei Stock Index reached an all-time high in December of 1989. 26+ years later, investors at that time still have not recovered their investment. And they’re not even close—they are still down well over 50% from that 1989 peak. Investing in Japanese equities in 1994, even after the market tanked for 5 years, would result in a yield of 0% return 21+ years later. It’s the lost three (and counting) decades for Japanese investors. Ouch! That would not be pleasant on your retirement accounts.

Japan Nikkei

The Japanese Nikkei 225 Stock Market Lost Decades

We don’t like speculating on those sort of things, or wondering if we’re running into one of those untimely market peaks or flat decades. That’s just too stressful…who wants that?

So we don’t speculate. We invest with predictable, long-term results.

We look at investing a bit differently.

For us and our students—it’s so much easier and less complicated to focus on individual, top-tier companies, with real predictable earnings and cash—concentrating solely on buying them when they are on sale. Not only is that easier—but it’s less risky, gives us greater potential for outsized returns, increases confidence, and it’s just more enjoyable and profitable than speculating on the economy or the direction of the entire stock market.

If we buy solid, high-quality and well-managed companies at valuations that we deem to be a good buy, then it makes no difference where the general market goes this year, or next. We simply do not worry about it. Continually applying this strategy, buying great companies on sale, we can’t help but make great returns over the long-term.

This is exactly what Warren Buffett, Charlie Munger, David Einhorn, and all the other great value investors have been saying and doing for decades. They don’t care where the market goes, or worry about timing it. They simply buy when the good companies go on sale. That simple. Over time, this strategy pays off…big time. Their results speak for themselves.

The truth is that we could come up with all sorts of reasons why the market should drop from here, and therefore not invest our money, or wait until it bottoms out. But none of that necessarily means that it will, and we certainly never try to time a bottom. The market can continue to be irrational for a long period; central banks around the world have seemingly endless amounts of money to continue to drive interest rates down and asset prices up. In other words, just because the market should go down (fundamentally speaking), doesn’t mean that it will.

We need to ensure ourselves that we will stand to profit and make some great returns over time, no matter where the market goes from here. We would much rather do this by investing with certainty, as opposed to speculating with hope.

The best way that we’ve found to do this is to know how to value companies, and have the discipline to buy only the best when they are on sale.

 

A Different Valuation Approach

Some of you reading this have followed us for quite some time. You know that we have never changed our investment approach. Since the beginning, our message has remained the same:

Buy top-tier companies at prices less than their value

In order to do this, most of our teaching has been centered around the face value calculator. It’s a basic present value calculator that simply projects a future stock price using:

  1. Earnings per share (EPS)
  2. EPS growth rate
  3. Projected price to earnings ratio (P/E ratio)
  4. Desired rate of return

Plugging those numbers in yields a face value, which we prefer to buy at a 50% margin of safety.

You can use it right here:

This calculator has worked fantastically for us and many students. As simple as it is, using it to value wonderful companies, and staying disciplined in applying it, has yielded returns that consistently beat the market.

The only drawback to using this valuation method is that it tends to be more conservative in nature. Conservative is good, but sometimes it can be too conservative. Since we typically use a 12%-15% desired rate of return, either the growth rate needs to be high enough to get those returns, or the purchase price needs to be heavily discounted.

It works very well for the high-growth or heavily discounted stocks, but does not allow us to buy into the more mature companies, or the blue-chips such as Microsoft, Nike, McDonalds, Under Armour or Coke.

In order to add a second check to all of our investments, and another valuation method to enable us to safely buy companies which might not work well with the traditional face value calculator, we look at the EV/EBITDA ratio.

This is a measure that we have not focused on with students before, because it can detract from the basic premise of buying top-tier companies at prices less than their value. In other words, it’s easy to get lazy and rely on only this tool without doing all of the other research required for great long-term investing. We’re showing you the EV/EBITDA ratio with the warning that you should not use it as your only tool in determining a fair price. A full evaluation of the quality of the company and determination of their future earnings should always be the number one priority.

The EV/EBITDA ratio stands for enterprise value (EV) divided by the earnings before interest, taxes, depreciation and amortization (EBITDA). Don’t let the bulky acronym and wordy explanation fool you into thinking this is complicated. It’s actually pretty simple and extremely useful. It’s a common measure that is found on most financial websites.

It’s just another way to measure how cheap or expensive a company currently is, relative to their industry or peers.

 

The Components of EV/EBITDA

Enterprise value is the total market value of a company. It’s more accurate than simply the market capitalization—which is the value of a company’s equity—because it factors in debt and cash on the company’s books. We like looking at the enterprise value because it’s a fair estimation of the price a private buyer would need to pay to buy the entire company.

The enterprise value is figured by taking the market capitalization (# shares outstanding X price/share), adding in debt, and subtracting cash.

For example, for Apple (AAPL), as of the quarter ended in December 2015, their enterprise value was $608.5 billion. This number was arrived at by taking the market capitalization of $583 billion, adding in total debt of $62.9 billion, then subtracting out the cash on their books of $38 billion.

This number fairly represents what a buyer would need to pay for Apple, because the buyer would have to pay off all of the lenders ($62.9 billion in debt), then the stockholders (market capitalization of $583 billion), and then they would have the remaining $62.9 billion in cash to add to their balance sheet.

A company with no debt would have an enterprise value very similar when compared with market capitalization. A company with high debt would have a much higher enterprise value compared with their market capitalization. Since we want to buy companies as their enterprise value is in the lower range, high-debt companies usually will not pass the test.

Of course, we need something to compare this enterprise value to. For that, we’ll look at earnings.

Since we have factored debt into the equation, we can’t just look at their net earnings. We need to look at the earnings before the financing charges for a fair comparison.

EBITDA, or earnings before interest, taxes, depreciation and amortization is the best measure that allows us to compare companies both with and without debt on a level playing field.

EBITDA is simply a clean and comparable measure of a company’s profitability—regardless of how the company has been financed.

As of the quarter ended December 2015, Apple had an EBITDA for the trailing twelve months of $85.2 billion.

Taking the enterprise value of $608.5 billion, and dividing it by EBITDA of $85.2 billion, we can see that Apple was trading for an EV/EBITDA ratio of 7.14. This means that if a private buyer wanted to purchase or takeover Apple, they would have to pay somewhere in the ballpark of 7.14 times earnings before financing charges in order to do so.

 

Applying the EV/EBITDA Ratio

Now that we have a clear definition of EV/EBITDA, and why it’s used—what kind of number should you be looking for?

Well first off, it’s important to remember that this is not the only valuation metric to use. You should always conduct a face value calculation first to see what kind of ballpark price range you are looking at.

Even more importantly, you should be sure you are only even attempting to value high-quality, well-managed companies—ones that you are happy to own in your portfolio for the next 10 years if need be. It’s hard to accurately time the bottom of a stock price, and holding onto a stock as it’s dropping is tough to do if you are unsure of it. If we are active buyers, we should be welcoming drops in value, so we can keep buying more of a great company with even further discounts.

All else being equal, a high EV/EBITDA ratio is considered expensive, a low EV/EBITDA ratio is considered cheap. With that said, whenever you can find a top-tier company that is trading with an EV/EBITDA ratio below 10, it’s time to dig in.

Wonderful, well-run and consistently profitable companies do not typically trade below an EV/EBITDA ratio of 10. When they do, it’s time to figure out why—and if Mr. Market is unfairly pricing them.

However, these multiples are different for each industry. A high-growth industry will tend to have much higher EV/EBITDA multiples than industries with little to no-growth such as railways.

A good test is to compare the EV/EBITDA ratio on a chart. The best place we’ve found to do this is at GuruFocus on the interactive charts. Here you can compare the historical EV/EBITDA ratio across the stock’s history.

For example, below is Apple’s historical EV/EBITDA chart for the last 10 years.

AAPL Apple EV/EBITDA

This shows what the ratio was in real-time. The circles represent the best buying times as the EV/EBITDA ratio plunged. Looking back, it’s obviously easy to see where the best times to buy were. Just as looking at a price chart, if we simply bought at the bottom…we’d be rich!

But that’s not how it works in real life. We don’t know what the bottom will be when we’re looking at a current chart, but we can combine this EV/EBITDA ratio with other factors.

Those factors are the same ones we have always used. Before getting to this point of the EV/EBITDA analysis, you should be satisfied with your answers to:

  1. The strength of Apple’s durable, competitive advantage
  2. The quality of their management and executive team
  3. The simplicity of the company and your ability to understand how they operate and turn a profit
  4. The predictability of their future earnings/cash flow
  5. The potential risks and future threats to Apple as a company

Like we said before, the EV/EBITDA ratio is just another tool to add to your stock investing toolbox. It gives you more confidence and a little bit clearer picture of how cheap or expensive a stock is. But it should never be used completely on its own to determine a fair price.

You may have bought Apple when it dropped below an EV/EBITDA ratio of 10 in early 2015, but would need to remain committed and confident holding on to it (and possibly buying even more) as it drops to an EV/EBITDA of 6.8 where it currently is. The best way to do this is to be diligent when going through the checklist above.

Just because a company has a low EV/EBITDA ratio does not mean they will go up. Conversely, just because a company has a high EV/EBITDA ratio does not mean they will drop. But it puts the odds on your side buying on the low, historical range. It’s a great additional tool to have in your arsenal as a value investor.

Let’s take a look at a couple more charts with the price overlaid on top. These are a few companies that were popular student purchases over the last year.

Michael Kors (KORS) was a high-growth stock in the fashion industry that was making a name for itself in the handbag industry, taking on the iconic Coach (COH) brand. It’s a company that we’ve liked over the past few years, but they just got to be too expensive in early 2014. Once their sales started to level off, the stock plunged in mid-2015.

Kors EV/EBITDA

The green line represents the stock price, the number scale on the left; while the blue line represents the EV/EBITDA ratio, the number scale on the right

After the stock plunge, the EV/EBITDA ratio reached levels it had never seen in the stock’s short history. It was selling for a ratio of about 6, dropping even below 5 for a short time. A company of Michael Kors’ quality, pristine balance sheet, and predictability did not deserve to sell this cheaply. They would have probably been bought out at a nice premium if they dropped much lower. And very recently, the market agreed—the stock has now moved up over 60% off of its lows.

Deckers (DECK) is a company we have loved since 2010, making three separate purchases in that span. Deckers is the maker of Uggs, the funny-looking, fluffy winter boots made out of sheepskin that has become a winter staple across the country. Uggs have exploded in popularity over the years, and shareholders who purchased at times of cheap valuation have been nicely rewarded.

DECK EV/EBITDA

The green line represents the stock price, the number scale on the left; while the blue line represents the EV/EBITDA ratio, the number scale on the right

In the winter of 2012, their EV/EBITDA ratio dropped to a low of about 5, which was crazy for a company of this caliber, management and future growth opportunities. In order to profit, we needed to be willing to hold onto (and purchase more) of this stock as it dropped from $40/share down to below $30/share. The valuations were extremely low, as evidenced by both the face value calculator and the EV/EBITDA ratio. Since we knew so much about the company, its management, risks, and competitive advantage—we were happy and confident that we were buying with a very large margin of safety.

The market later rewarded us.

It happened again more recently with this company. Mr. Market became a little bit depressed and sent the EV/EBITDA ratio down to its previous 2012 low of about 5 at the beginning of 2016. Since then, the stock has moved up over 35% off of its low.

 

Putting It All Together

I want to close this out by reminding you that EV/EBITDA should not be used on its own.

You probably noticed that had you simply bought some of these companies below a ratio of 10, you still could have been down quite a bit of money. There is no magic number or ratio, and buying low-quality companies, or companies that are on the decline will yield poor results no matter how low of an EV/EBITDA ratio you purchase at.

It’s simply another tool to use in our evaluations of companies for purchase. It’s a way to see how cheap or expensive they are, relative to their history, and relative to other companies within their industry.

Don’t forget that a great stock investing strategy should always entail buying top-tier companies at prices less than their true value. In order to apply this, let’s bring back the five main points you should understand, explain, and be happy with the answers to:

  1. The strength of a company’s durable, competitive advantage
  2. The quality of the management and executive team
  3. The simplicity of the company and your ability to understand how they operate and turn a profit
  4. The predictability of their future earnings/cash flow
  5. The potential risks and future threats to the company

The margin of safety valuation and EV/EBITDA ratio comes into play after you understand those points. This is because quality of the company is even more important than the price. Sure, the price is extremely important, but top-tier companies will yield far better results over time than low-quality and unpredictable ones—no matter the price.

As I wrap this explanation up, I keep hearing my favorite quote from Charlie Munger in the back of my head. Charlie Munger is Warren Buffet’s investment partner and right-hand man. A billionaire himself, and probably regarded as the world’s second best investor with a track record of 20%+ annualized returns, Charlie has been credited by Warren Buffett as making him a much better investor.

charlie munger

Charlie Munger

His quote is perfect to leave on:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”

Never forget this. The EV/EBITDA ratio will help you significantly in determining when wonderful companies are selling for fair to wonderful prices. If you can find wonderful companies, and maintain the discipline to buy them as they are relatively cheap, and do this over and over again, investing your money becomes a long-term game with increased possibilities for success.

I think that’s much better than speculating on where the market or economy is headed from here.

 

Tudor Coaching Group offers online courses on stock investing and retirement, as well as weekly webinars for current stock analysis and trainings. You can learn more by checking out the Investment Intel, or the Ultimate Stock Market Investing Course.

 

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Kevin Tudor is the VP of Investment Training for Margin of Safety Investing, LLC. After a significant amount of time in the financial services industry, Kevin moved on to investment research and analysis to bring his expertise to the individual investor. He now resides in Scottsdale, Arizona where he conducts online newsletters, webinars, and various investment trainings to show others the key strategies to successful investing.

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