For understanding a business rather than a corporate structure – EV/EBITDA is probably my favorite price ratio.
Why EV/EBITDA Is the Worst Price Ratio Except For All the Others
Obviously, you need to consider all other factors like how much of EBITDA actually becomes free cash flow, etc.
But I do not think reported net income is that useful. And free cash flow is complicated. At a mature business it will tell you everything you need to know. At a fast growing company, it will not tell you much of anything.
As for the idea of maintenance cap-ex – I have never felt I have any special insights into what that number is apart from what is shown in actual capital spending and depreciation expense.
When looking at something like:
- Dun & Bradstreet (DNB)
- Omnicom (OMC)
- Carbo Ceramics (CRR)
I definitely do take note of the fact they trade around 8x EBITDA – and I think that is not where a really good business should trade. It’s where a run of the mill business should trade.
I guess you could get that from the P/E ratio. But when you look at very low P/E stocks – like very low P/B stocks – you’re often looking at stocks with unusually high leverage. And this distorts the P/E situation.
Which Ratio You Use Matters Most When It Disagrees With the P/E Ratio
The P/E ratio also punishes companies that don’t use leverage.
Bloomberg says J&J Snack Foods (JJSF) has a P/E ratio of 21. And an EV/EBITDA ratio of 8. Meanwhile, Campbell Soup (CPB) has a P/E of 13 and EV/EBITDA of 8. One of them has some net cash. The other has some net debt. J&J is run with about as much cash on hand as total liabilities.
They can do that because the founder is still in charge. But if Campbell Soup thinks it can run its business with debt equal to 2 times operating income – then if someone like Campbell Soup buys J&J, aren’t they going to figure they can add another $160 million in debt. And use that $110 million in cash someplace else.
And doesn’t that mean J&J is cheaper to a strategic buyer than its P/E ratio suggests.
That only deals with the “EV” part. What about the EBITDA part? Why not EBIT?
Don’t Assume Accountants See Amortization the Way You Do
The “DA” part of a company’s financial statements is usually the most suspect. It’s the most likely to disguise interesting, odd situations.
Look at Birner Dental Management Services (BDMS). The P/E is 21. Which is interesting because the dividend yield is 5.2%. That means the stock is trading at 19 times its dividend (1/0.052 = 19.23) and 21 times its earnings. In other words, the dividend per share is higher than earnings per share. Is this a one-time thing?
No. The company is always amortizing past acquisitions. So, the EV/EBITDA of 8 is probably
