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# EBITDA: The Holy Grail of Stock Valuation, Part II

#### Alexis Evidente

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Today I dive a little bit deeper into how to use EBITDA (Earnings before, interest, taxes, depreciation and taxes) in stock screening and valuation.

As mentioned in my last article, the term P/E is thrown around a lot by the financial media. I started thrashing the idea of using the P/E method to value stocks without really breaking it down in more detail. First of all, P/E means price to earnings, hence P/E.

The P equals the price of the underlying security. So, for a real life example we can look at Coke, trading symbol KO.

For the next couple of sections we are going to rely on Yahoo Finance for our data.

If you quickly check Yahoo Finance, you can see that Coke is trading at \$58.64. You may be asking yourself what makes the stock price \$58.64?

(Note: all data as of March 5, 2010)

First we need to look at the income statement and go to the net income line. Go ahead and try it with Coke. It says that Coke’s net income last year was \$9,091 million. Now we need to click on the balance sheet and look for the number of shares outstanding, which were 2,312 million shares on the balance sheet date.

We now divide Net Income/# of shares outstanding to arrive at EPS (Earnings Per Share).

EPS is \$3.93.

We know that the stock is \$58.64 and the EPS is \$3.93. \$58.64/\$3.93 = 14.93. Therefore, Coke has a P/E multiple of 14.93x.

Before moving any further let’s solidify this concept with a few more examples:

If EPS is \$2.00 for company XYZ, and you apply a multiple of 10x, your stock price is \$20.

If EPS is \$7.00 for company ABC, and you apply a multiple of 50x, your stock price is \$350.

To go one step further—if a company currently earns \$0.50 per share (EPS) today and its shares go for \$5.00, you know it’s P/E multiple is 10x. So you put on your thinking cap and you think the company will earn \$1.00 EPS next year. You know the market is current applying a P/E of 10x to your company so you can expect that your company will be worth \$10 next year (P/E of 10 x \$1 EPS = \$10.00). Based on this logic, it seems that the stock is very undervalued today.

Congratulations ---you understand the very essence of valuing a stock using the P/E method. However, as motioned in Part I there are many issues in looking at net income but the best type of investor is an informed investor and you are now armed with better knowledge as to how the P/E method of stock valuation works.

As previously mentioned, net income comes with many built in flaws, but let’s point out one more serious flaw about using a P/E multiple. The P/E method of valuation only considers the equity portion of a company. Equity is what the owners have claim to. Every single company is structured by taking its equity value and adding it total liabilities. This is called Invested Capital. Think about it this way—look at yourself for a moment, and consider all your assets and debt. When we look at P/E we are only pricing the equity side of business and not considering the debt. This is another crucial flaw of using P/E, and blows my mind how easily this term is accepted in the financial media.

How can you value a business without considering the debt portion?

You really can’t!! If you want to make money in the market you need to know both the equity and the debt of a company.

Here is your secret weapon in finding great investment ideas and super undervalued stocks. Use Enterprise Value (EV) and divide it by EBITDA to get an EV/EBITDA multiple.

What is Enterprise Value you ask?

Enterprise Value = Market Value of Equity + Total Debt – Cash.

Let’s calculate the EV for Disney (DIS)

Market Value is \$64.43 billion

Total Debt is \$11.49 billion

Cash is \$3.41 billion

Enterprise Value (EV): \$72.51 billion

Why do we use EV?

Glad you asked! EV represents what the true worth of the business if it was to be acquired.

So if we decided to purchase DIS we would have to pay \$64.43 billion for the equity, but we also have to assume all the debt which will have to be paid off at some point and of course you can expect all the cash to be gone.

Think about this way. You go buy a car. The total cost is \$20,000, but you only put \$2,000 down. You still owe \$18,000.

The equity portion that you own is worth \$2,000 and the total debt is \$18,000. The EV of your car is \$20,000.

Of course, this is not a perfect example because cars go down in value over time and the stocks we pick at CR Investor go up in value over time. But I think it serves the point.

Now to EBITDA.

How do we calculate EBITDA?

Let’s go back to another real life example. Let’s look at PetroChina (PTR).

We examine the income statement but this time we stop at operating expenses.

So from Yahoo Finance Petro China has the following:

Revenue: \$157.13 billion

COGS: \$94.77 billion

Gross Profit: \$62.35 billion

Total Operating Expenses: \$38.98 billion

Operating Income, aka EBIT: \$18.57 billion

EBIT means Earnings, before Interest and Taxes. (Please review Part I for why we look at this)

We now add back the depreciation and amortization? Why, because it’s not a real expense and is simply an accounting entry. Depreciation and amortization is a non-cash expense and the company did not incur any cash outflows.

When we do this we get to EBITDA.

To find the depreciation and amortization numbers we need to look at the cash flow statement under operating cash flow. Let’s do this real quick for Petro.

Depreciation and Amortization: \$13.87 billion

EBITDA for Petro China: \$32.44 billion

You take EV/EBITDA and you know have an EV/EBITDA multiple for Petro China of 2.23x.

Why is this powerful?

When looking at EV/EBITDA multiples we are considering the total capital structure of the company and also looking at how expensive it would be for the company to be acquired. When we compare this to EBITDA, we are able to truly capture a company’s true earnings power which is essential. This multiple provides a ton of insight into the true worth of a company.

The last part of my three part series will look at EV/EBITDA multiples and how to determine what is a low and high multiple. I will also explain how we used EV/EBITDA to find companies like Joe’s Jeans (JOEZ), which we recommended at \$0.22 and is now \$2.13, and Hi-Shear Technology (HSR) that returned over 199% before being bought out.

If you really want to see our investment process in action please go to our site www.CRInvestor.net. You will find unbelievable research and reports that captures the true essence of value investing and education. We show our members how to become better stock pickers by sharpening their valuation skills. Our reports provide institutional level research never seen before on the retail level. Not to mention that our results in 2009 outperformed the S&P by 69.6% and we have the brokerage statements to prove it!

Happy Investing,

Alexis Evidente

www.CRInvestor.net

Alexis Evidente
Alexis Evidente: Alexis has been investing for over 16 years and over this time has refined his investment strategy to resemble the value investing style of Peter Lynch and Warren Buffett. Through his time spent providing expert valuations for clients of companies such as Citigroup, Bear Stearns and Marshall-Stevens, Alexis has continued to refine his investment philosophy. With the help of his fellow colleagues at Clear Research, Alexis created a new investing strategy focusing on value and growth, with a keen eye on multiples that would attract investment by private equity firms. Visit www.CRInvestor.net

Visit Alexis Evidente's Website

 Currently 4.50/512345 Rating: 4.5/5 (34 votes)

Yswolinsky - 4 years ago
can you post a direct link to Part I. I would like to read it but cant find it.
Kfh227 - 4 years ago

I still think FCF is better. Granted EBITDA beats plain ol' PE.
Billy Basu - 4 years ago
You better check your EV valuation of PetroChina - there is no way this oil giant is valued at 2.23x EBITDA! I am surprised that you did not pick up on such an obvious dirt cheap valuation error.
Tk79 - 4 years ago
Excellent job. I appreciate the thorough explanation and examples in your article.
ValueFans - 4 years ago
The EV/EBITDA multiple was approximate at 9.7x as of your valuation date 3/5/2010. It does not seem to be very cheap with this high multiple. I think you might forget to convert to U.S. dollar when you calculate the EV/EBITDA multiple originally.

Good article anyway and glad to hear the diversified opinions on Guru.
Amz33 - 4 years ago

Great article guys, very informative. Keep up the excellent work! Your selection of JOEZ really got my portfolio off to an unbelievable start in 2010! I'm crushing the market so far. Keep the recommendations coming!
Robert Sprinkel - 4 years ago
I'm with the other reader that couldn't find Part I on the CR website. It would be very useful if you could post both Part I and Part III when it is available.

About Part II: This is a very clear explanation. If is probably the most valuable metric for valuing any company, but, as an MLP investor, it is ESSENTIAL. No one investing in MLPs should place any metric in front of EV/EBITDA. PE is useless.

Thanks for providing this. I hope you can post Part III
Extramiler - 4 years ago
Buffett has said a thousand times that EBITDA is a phony number because it ignores cap ex and taxes. [size= 14px][/size]

"When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder -- does management think the tooth fairy pays for capital expenditures?"

"Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"

Berkshire Hathaway 2002 Annual Report

Robert Sprinkel - 4 years ago
I don't think Warren and Charlie invest in MLPs (and I hope they never do!). EBITDA is a very important metric in the MLP space. I'll stand with that.
Alexis Evidente - 4 years ago
Sorry about that. If you e-mail me at aevidente@clearresearch.net I will send you part I myself.

Alexis
Alexis Evidente - 4 years ago
We use EV/EBITDA as a starting point and how the market currently views the company. We than perform a discounted cash flow analysis (DCF) where we get to the Debt Free Cash Flow of the company. Here are the line items

EBIT

- Taxes

+ Depreciation and Amortization

(+/-) Change in Working Capital

- Capital Expenditures

After performing our DCF analyssi we check the implied EV/EBITDA based on our valauation.

Amz33 - 4 years ago

Hey everyone,

I found part I and II. Use the link below! Looking forward to part III!

http://www.crinvestor.net/FreeReportsArticles.aspx
Port45 - 4 years ago
Both P/E or EV/ EBITDA will work for steady predictable business in both sales and capital expenditures and neither metric will work alone when this isn't the case. However, you should never trust that a company that has historically been a steady Eddie will be so going forward. What you really want to know with equity valuation is Price/ forward FCF. The problem with EBITDA is you don't want to ignore depreciation if it is the best measure of future maintenance Capex and a problem with PE is you wouldn't want to apply a historical avg PE multiple to a fluke year of high EPS when projecting a price target. The real answer to good valuation is to dig deeper to find what amounts of free cash a business is going to throw off to investors in the coming years. I would say knowing EV is important if you think a business has a chance of being acquired, asking yourself what companies could absorb this level of EV and would they pay a premium?
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