Various multiples, like price-to-sales, price-to-earnings and price-to-free cash flow are often used in describing a company’s stock price. These are simple and quick metrics that can give insight into how a stock is priced. Multiples are informative data points and helpful in describing a company’s stock price but we believe they are unable to measure a company’s ultimate intrinsic value. Here we discuss two often-cited multiples (P/E and EV/EBITDA), their usefulness, shortcomings and how we at EBS evaluate intrinsic value through our investment decision making process.
Price to Earnings (P/E)
The P/E ratio is likely the most commonly referenced multiple in financial publications. It is simply stock price divided by earnings per share (EPS), or alternatively market capitalization divided by net income. This can be helpful in comparing a company’s stock to industry peers, its own historical multiple and the market. However, this ratio is only a snapshot in time. It can be distorted by several factors including irregular or extraordinary charges, business cyclicality and accounting policies. Additionally, the earnings portion of the P/E ratio is derived solely from the income statement; further analysis is needed to assess balance sheet, cash flow and return on capital considerations.
Enterprise Value (Market Cap + Debt – Cash & Cash Equivalents) to Earnings Before Interest, Taxes, Depreciation & Amortization (EV/EBITDA)
Unlike P/E, the EV/EBITDA multiple adds back some non-cash charges (D&A), attempting to capture a view of core operating profitability. In our view, focusing on operating income (less noisy) can be more informative than earnings. Additionally, by adding back debt in the EV calculation the multiple allows better comparison between companies with different capital structures. While it may improve on the basic P/E calculation, it has its shortcomings as well. It largely ignores capital expenditures, which are real cash outlays needed for maintenance and growth of the business. Also important, EBITDA is not a perfect proxy for cash flow as it does not account for interest, taxes and changes in working capital. Similar to the P/E ratio, in depth analysis of a company’s balance sheet and return on capital capabilities is needed to make an informed opinion of intrinsic value.
EBS Philosophy
Multiples can be quick, helpful metrics to assess prices but in our view are no substitute for fundamental business analysis. These are snapshots of how the market is pricing a stock, not an estimation of its intrinsic value. Our investment process is rooted in finding businesses with durable moats (competitive advantages), strong balance sheets and the potential for persistent high return on invested capital (ROIC). We must make assumptions on growth, risks and future cash flows…discounting these to arrive at an internal estimate of a company’s intrinsic value. Finally comes one of our core values: Margin of Safety. We have no crystal ball and recognize much of the future is unknowable. It is only when the market prices a stock comfortably below our estimate of intrinsic value that we make the decision to invest. Investing with a margin of safety can help minimize the risk of a permanent loss of capital.
Conclusion
Although valuation multiples provide a simple yardstick, they do not reflect a company’s intrinsic value. In our view, there are no shortcuts to analyzing a business. Only through thorough fundamental analysis can an investor form a reasonable assessment of a company’s fair value. Additionally, the future is unknown and accurately forecasting growth rates, earnings and performance is a fool’s errand. Therefore, we require a margin of safety in any investment we make which we believe allows room for error and can help reduce the risk of a permanent loss of capital.
This material is provided for informational purposes only and does not constitute investment advice or a recommendation to buy or sell any security. Any discussion of investment strategies or philosophies is intended to describe our general approach and does not guarantee future results. All investing involves risk, including the potential loss of principal.