(Part I can be found for free at www.CRInvestor.net)
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!