The purpose of today’s lesson is to thoroughly understand the EV/EBITDA metric—its uses and abuses and how to place the metric into context.
A hard look at a valuation ratio: EV/EBITDA.
This post will give you more background to the metrics discussed in Lecture 1 found here.
Here’s what Charlie Munger had to say at the Daily Journal meeting
Charlie Munger spoke at the Daily Journal Corporation's Annual Meeting of Shareholders today. Although Warren Buffett is the more well-known Berkshire Hathaway chief, Munger has been at his side through much of his investing career. Q4 2020 hedge fund letters, conferences and more Charlie Munger's speech at the Daily Journal meeting was live-streamed on Yahoo Read More
Valuation Ratios: Enterprise Value to Earnings before interest, taxes depreciation & amortization or (EV/EBITDA).
EBITDA are bullsh*t earnings! – Charlie Munger
EBITDA multiples are used to value or benchmark businesses. Unfortunately, the multiple changes with capital intensity, nature of the business, competitive position of the firm, and sustainability of the cash flow. Like a chain saw, EBITDA should have a warning label, “This tool can be dangerous if used improperly.”
Some operations managers like to use EBITDA as an internal metric which is under their influence. EBITDA is subject to GAAP guidelines, which means interpretation of how revenue is booked, etc. but management can get a sense of the “cash flows” available for debt capacity and capital expenditures. Some analysts like to be able to make comparisons using EV/EBITDA because this metric strips out debt, tax and fixed investment policies of the businesses they are comparing. These analysts feel that they are making more of a raw comparison.
But the value of a business depends on the amount of net cash you can receive from the business discounted back to today at your required rate of return plus the non-operational assets, so EBITDA can’t be used to determine intrinsic value.
Even though EBITDA can be misused, there are always problems with metrics like Price-to-earnings ratios (P/E) for example: with a forward looking numerator and a denominator arising from the past, is it any wonder that P/E ratios are faulty indicators of value?
You will understand after reading the lessons and listening to the lectures why comparisons like:
This company is “cheaper” because it trades at an EV/EBITDA multiple of five times compared to its peers that trade at seven times EV/EBITDA can be misleading.
OK, back to EV/EBITDA.
Enterprise Value (“EV”)
To look at stocks as a business you must know the current price of the corporation or enterprise value.
Enterprise Value or the asset value of the company is the price you would pay for the entire business based on the current market price of the company’s share and net debt. This metric assumes that the worth of a company is the sum of all outstanding obligations (stocks, bonds, and debts) minus the cash the company has on hand not needed for the business operations. The formula is: EV = Mkt. Cap of equity + Preferred Stock + Debt – Cash Equivalents in excess of business needs for one year.
An excellent 15 minute video explaining the advantages of using EV and how to calculate EV is here:
Ignoring the capitalization structure (debt) of a company while just looking at equity market capitalization would be similar to a pilot ignoring a fuel gauge before takeoff. Click on this link to realize what can happen (go to 4 minute mark). http://www.youtube.com/watch?v=s_L6F2VIevI&feature=related
A quick explanation: http://www.youtube.com/watch?v=ASEokM_1wsg&feature=related
A thorough fifteen minute lecture on understanding EBITDA:
Comparing two companies with different capital structures; say one company has debt and the other has surplus cash and no debt using price earnings ratios would be misleading. Buffett and Graham say to look at stocks not as flashing prices on a green screen, but as businesses. To know what the market price of an entire business would be you must use enterprise value (“EV”).
Thinking inversely, you would realize that debt-free companies with no surplus (non-operational) assets like cash would have EVs equal to their market capitalizations; therefore, P (mkt. price x fully-diluted shares outstanding) = EV.
Calculating and using the EV/EBITDA metric is discussed in the excellent 10-minute lecture below: http://www.youtube.com/watch?v=Io13yp6caoY
Once you embrace the metric of EV, you will understand the problems with using a price-to-earnings ratio which is calculated: the market price of the equity (market share price multiplied by fully diluted outstanding shares) divided by one year’s profit after tax or Earnings.
$10 market price of a share times 900,000 fully diluted shares = $9 million; Earnings are $1 million so Price/Earnings = $9 million/$1 million = 9 P/E
Using EV/ (EBITDA-MCX) will give you a better pre-tax operational metric to compare businesses than P/E or EV/EBITDA. We will cover maintenance capital expenditures (MCX) in another lecture.
For several cases studies analyzing EBITDA as a metric go to the 35-pages scribd document here.
You will know more about EBITDA than professional analysts. Use the case studies to improve your skills.