Iolite Partners – Financial Ratios: Beware The Oversimplification Trap

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

Financial ratios

This presentation will analyze oversimplification traps when using the following common three financial ratios

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  • 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


Iolite Partners Financial Ratios Oversimplification Trap

  • 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)

Iolite Partners Financial Ratios Oversimplification Trap

See full PDF below.