If you’re new to investing, there’s one thing you should know: investors are lazy. If you’re an experienced investor, you should already know this because you are lazy. With thousands of stocks listed in the US alone, investors are too lazy to do in-depth research on them all. Looking at valuation helps investors quickly judge a company and compare them vs. peers.
Common Valuation Methods
Besides, comparisons are nearly impossible because companies are like snowflakes. No, not easily offended wusses, although that does accurately describe some companies and CEOs. Companies are snowflakes because they’re all unique. No company is exactly the same as another. Each company has a different CEO, different offices, different employees, and different customers. Yet as an investor, you need to find an easy way to compare them all, so you can pick the best investments out of the group.
That’s the point of valuation methods. It’s a way to value the business but also easily compare different companies versus each other. When valuing companies, the most common valuation methods are P/E, EV/EBITDA, and P/FCF. Just know that a lower number implies a stock is cheaper relative to higher numbers. Also know that when you compare stocks, you have to use the same valuation metric. You can’t use the P/E of one company and the EV/EBITDA of another one for comparison purposes.
Price to Earnings
Price to earnings, or P/E, is the most common-used valuation metric. The price is the share price of a stock. The earnings is on a per share basis or Earnings Per Share (EPS). For example, if a stock has a share price of $30 and earnings per share of $2, then it would have a P/E of 15.0x.
Earnings for a company is the net profit after all expenses. This means revenue, less costs of goods sold, general and administrative, depreciation, interest, and taxes. At the end of the day, you buy a company for its profit, which is why many investors are focused on profit. Note that profit is the not the same as free cash.
When companies compile an income statement to report earnings, they follow what is known as Generally Accepted Accounting Principles (GAAP), although they’ll sometimes make adjustments to make it non-GAAP. In the income statement, you’ll notice that depreciation is a non-cash expense. When an item like a car depreciates, you don’t actually spend cash on the depreciation. Depreciation is an accounting method to account for the fact that capital equipment depreciates and over time, you’ll need to budget to replace the equipment.
So when a company reports earnings, they’re smoothing out fluctuations in spending, such as large capital equipment purchases. This is a good thing because these purchases usually have long-term benefits. For example, if a company builds a new factory one year, it’ll incur a large capital expense that year, but it’ll get a benefit from this factory for many years. GAAP accounting will smooth out this cost over many years.
Enterprise Value to EBITDA
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Because we’re looking at the profitability of the company before taking into account leverage (interest expense), we can’t just use the share price. That’s why when looking at EBITDA, you need to look at the Enterprise Value (EV). Enterprise value is the market cap of a firm, plus the net debt. For example, let’s say a company has a share price of $30 and it has 100 shares outstanding. This means it has a market cap of $3,000 (30 x 100). Let’s say it has net debt (debt less cash) of $1,000. So its EV would be $4,000. If it had EBITDA of $500, it would be trading at 8.0x EBITDA ($4,000 divided by $500).
With P/E, earnings is the profit that flows through to the equity holders, since we’ve subtracted the interest expense. That’s why we have the share price in the numerator, because both price and earnings only considers the equity holder.
With EBITDA, it’s a measure of profit that could potentially go to both equity and debt holders. That’s why we use EV, since it includes both the value of the equity (market cap) and the debt (net debt).
Why I Don’t Like EBITDA
Investors like to use EV/EBITDA as a valuation metric for companies with high leverage or ones that have high capital expenditures that are expected to come down over time, because both of these things will make EPS low. I’m not a fan of EBITDA precisely because it excludes so many expenses. Depreciation and amortization may not be cash expenses, but interest and taxes are. Also depreciation is a normalization of capital expenditures (capex), which is a real cash expense.
Other times when investors like to use EBITDA is when earnings is negative, or a very small number, since a very high P/E or negative earnings makes P/E a useless valuation metric.
Price to Free Cash Flow
We’ve already discussed the price of a stock (the share price). Free cash flow is a amount of cash a business generates over a period of time. To compute free cash flow, it’s all the cash that comes in, less cash going out the door for normal business operations, and capital expenditures. This is usually expressed as cash from operations less capex.
As discussed in the past, I prefer looking at P/FCF since it’s the actual cash that a company generates. However, you need to be somewhat careful when looking at free cash flow because timing can affect the numbers over a period of time. For example, as discussed above, abnormally large capital expenditures will impact FCF but have a smaller impact on earnings. Also, companies may benefit from the timing of receivables and payables, boosting FCF for a period of time, like a quarter.
What About P/S and DCF?
Less common valuation methods are using Price/Sales, or (P/S) and a discounted cash flow analysis, or DCF.
P/S is not used as much because companies can have very different profit margins, so you don’t really want to value a business solely on how much revenue it generates. For example, let’s say you have two companies. One makes 50 cents of profit for every dollar of revenue, while another only makes 5 cents of profit. Clearly, the one that makes 50 cents of profit for every dollar of revenue is a much better business.
P/S is generally used for companies that don’t have any profits, so the only way you can give it a multiple is off sales. Or the company is growing quickly and is subscale, so the current profitability isn’t representation of how profitable the company will be in the future.
Any finance textbook or professor will tell you a DCF is the correct way to value a business because at the end of the day, you’re buying a company for it’s cash flows. However, the problem with a DCF is there’s too much uncertainty around future cash flows and the valuation is too sensitive around the discount rate. You tell me what a stock should be worth, and I create a reasonable DCF to get you that valuation.