One Ratio to Rule Them All: EV/EBITDA
By Geoff Gannon
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 a more honest gauge of the company’s price than the P/E of 21. Basically, it’s trading at the equivalent of about a 15 P/E. The distance between the stated P/E of 21 and 15 is the result of amortization charges with no relevance to present cash outlays.
The notes to the financial statements make this obvious. The statements themselves do not. Screeners don’t read notes. So, if you’re using a P/E screen – you’re missing out on stocks with interesting notes on amortization.
The P/E Ratio Has a Big Blind Spot: Non-Cash Charges
Control buyers read notes.
So why use a screen that forces you to ignore them?
A P/E screen does just that. It’s like gouging out one of your eyes. True, 90% of the time you only need one eye. But sometimes it helps to have depth perception. And for that, two eyes are better than one.
The same is true of EBITDA. Most of the time, you can assume the accountants have painted a roughly right economic picture with GAAP earnings. But sometimes the picture they’ve painted is entirely misleading. It helps to see that.
Free Cash Flow is a Conservative Measure – Not an Accurate Measure
Now, you could argue that free cash flow is the best measure of a company’s earning power. And under certain circumstances I won’t argue with that. For example, at Dun & Bradstreet it’s clear that free cash flow doesn’t understate “owner earnings” because the company doesn’t spend cash on growth.
But what about Carbo Ceramics? Don’t we need a way to compare companies like Dun & Bradstreet with companies like Carbo Ceramics? And how do we do that with free cash flow? All free cash flow tells us is that DNB is very profitable and not growing. While Carbo is reinvesting everything in its growth.
I’m not sure free cash flow can tell us anything about the relative valuation of DNB shares versus CRR shares.
It might actually be safer to always use free cash flow rather than either GAAP earnings or EBITDA because it is a more conservative number and because it favors mature businesses.
Maybe we can argue free cash flow is a useful number. A conservative number. But we can’t possibly argue it is an honest number. If EBITDA is wrong because it completely disregards the real expense present in “DA” than free cash flow is equally wrong because it completely disregards the portion of cap-ex that is not an expense. An investment is not an expense.
No Price Ratio Captures the Value of Reinvestment – Only You Can Do That
We always have to look at how much value is created or destroyed when a company invests in growing its business. It makes perfect sense to disparage the use of EBITDA in an industry where the top players are earning 6% on tangible equity. It makes less sense when they are earning 16%.
And this is always the problem. Companies are not really comparable. Industries are not really comparable. And no form of accounting – cash or accrual – can capture all of these differences for the analyst or investor. You have to read the SEC reports for that. No single ratio will ever work for all businesses in all industries.
Why I Prefer an EV/EBITDA Screen to a P/E Screen
What I want in a single price ratio is something that is not going to eliminate interesting situations – like BDMS – because it is completely blind to them.
So, if I can screen for stocks by P/E or by EV/EBITDA, I’m going to use EV/EBITDA.
Obviously, it is “owner earnings” that matter most. But I have not found any financial website that is kind enough to calculate that number for every stock out there.
So, if we are talking about a single price ratio to get me started on researching a stock – I have to go with EV/EBITDA.
Every Ratio Misses Something – Like Companies With 0% Tax Rates
No price ratio is perfect. Bloomberg says Carnival (CCL) has an EV/EBITDA ratio of 10. Now, you might think the “DA” part of a cruise company – since they spend so much on very long lived ships – is going to be the most important thing to worry about when thinking about the EV/EBITDA ratio.
And that would be true, except…
Cruise companies don’t pay taxes.
So when a cruise company and a railroad both have an EV/EBITDA of 10 – the railroad is going to pay 35% of its income to the government, the cruise company is going to pay 0%.
That’s a hell of an asterisk.
Only You Can Calculate the One Ratio That Matters: Price-to-Value
So EV/EBITDA falls flat when a company pays no taxes. Every price ratio fails part of the time. Every ratio will mislead you about some stocks.
There is no substitute for reading the 10-K.
Empirical Evidence Supports the Use of EV/EBITDA – Read Greenbackd
One of my favorite value investing blogs is Greenbackd. Last month, Greenbackd asked “Which Price Ratio Outperforms the Enterprise Multiple?”. The answer: Nothing.
Greenbackd also did a a post called “Which Price Ratio Best Identifies Value Stocks?”. The answer: EV/EBITDA.