Iolite Partners‘ ValueX presentation by Robert Leitz from 2012 titled, “Financial Ratios: Beware The Oversimplification Trap,” discusses how to analyze oversimplification traps using three financial ratios EV/EBITDA & Capital Intensity, Net Cash & Control Premium, Net Cash & Working Capital and Growth of Book Value & Ponzi Schemes.
Financial Ratios: Beware The Oversimplification Trap
This presentation will analyze oversimplification traps when using the following common three financial ratios
- EV/EBITDA & Capital Intensity
- Net Cash & Control Premium
- Net Cash & Working Capital
- Growth of Book Value & Ponzi Schemes
EV/EBITDA & Capital Intensity
Would you rather invest in business A or B
Would you change your mind if you learned that
- EBITDA blends out the capital intensity of a business and is a rather poor indicator of FCF. So why is the whole world (almost only) talking about EV/EBITDA?
- Is it possible to draw any relevant conclusion on valuation levels of a stock market by using EV/EBITDA without having analyzed the industry weighting of the index over time?
Net Cash & Control Premium
Would you go long shares of the following business:
- Net cash: 4,000,000
- FCF (stable): 100,000
- Market cap: 4,000,000
Would you change your mind if net cash is held in
- USD (cash)
- US treasuries
- Japanese Yen (cash)
- Japanese treasuries
- Chinese Renminbi (cash)
Would you rather own a business with
A. good capital allocation at 5x FCF and 0% cash/market cap
B. bad capital allocation at 8x FCF and 50% cash/market cap
Would you put a higher value on the control premium in A or B?
Net Cash & Hidden Leverage
In March 2010, Dart Group, a leisure services aviation and distribution group, was trading at 73% net cash
- Net Cash GBP 51.6 m
- Market Cap GBP 70.0 m
- FCF GBP 41.1 m
Should you discount net cash because working capital is negative?
- Cash GBP 52.2 m
- Inventory GBP 0.3 m
- Receivables GBP 41.9 m
- Payables GBP -23.9 m
- Unearned Revenue GBP -121.4 m (advance payments)
- = Working Capital of GBP -50.9 m
And obviously, as with all airlines, there is high operating leverage (leased airplanes, high fix-cost base but volatile demand)
See full PDF below.