Thursday, September 25, 2014

P/E ratio VS Enterprise Multiple

At first glance, the enterprise multiple (enterprise value/EBITDA) would seem to be the better valuation metric as it looks more complicated and isn’t as common as the P/E ratio. But style points aside, both the enterprise multiple and the P/E ratio are inadequate at gauging the value of a company (at least without some adjustments). Both of these ratios use accounting earnings (EBITDA and earnings per share) as inputs; accounting earnings may overstate or understate the company’s true earnings power. To make the two ratios more useful, accounting earnings should be replaced by your estimate of the company’s true earnings. I know some of you may be thinking “fuck you Greedy Dragon, I saw you use the P/E ratio in some of your stock analysis.” Well, I did. But I use the P/E ratio only when reported earnings per share aren’t too far off my estimate of true earnings. To calculate true earnings, I start with net income and subtract or add back one-time items that are not likely to recur such as restructuring costs or gain on sale of subsidiary. I then add back depreciation/amortization/depletion and subtract capital expenditure needed to maintain the business (not for growth). I also average out certain items to ensure that they’re not overly optimistic; for example, I might average out a bank’s loan charge-off rate over 6 years to make sure that this year’s charge-off rate isn’t particularly low. To calculate true EBITDA, I would start with reported EBITDA and subtract or add back one-time items, subtract maintenance capex and average out certain items.  

Updates on the Greedy Dragon portfolio: I recently increased my stake in Biostime International. I also sold my stake in Kasikornbank recently.

Now that we’re done replacing accounting earnings with true earnings, let’s find out which ratio is better at telling us whether a company is undervalued or overvalued. As a shareholder, all I care about are profits. The enterprise multiple doesn’t give a shit how much profits are coming the shareholders’ way. EBITDA represents cash flow attributable to both debt holders and shareholders. What if the company has a ton of debt in its capital structure and most of its EBITDA is used to make interest payments? The enterprise multiple won’t be very useful for retail investors in such situations. The enterprise multiple is effective if you’re a large, strong company looking for takeover targets. If too much of the EBITDA is going to debt holders, a strong company can raise cheaper debt to retire the more expensive debt of its acquisition target. I guess retail investors can use the Enterprise multiple to see whether a loss making company is stupidly undervalued and could therefore be a target for other companies or private equity firms. But most of the time, I think that retail investors would be best served by investing in companies that consistently generate good profits (that yummy, delicious stuff that can be paid out as dividends, repurchase shares or reinvested in the business to create more shareholder value). With that in mind, I will have to say that the P/E ratio is a better tool for retail investors.  

Of course, I think that a NPV analysis is a much better valuation tool than both the P/E ratio and enterprise multiple. But when presenting my analysis, it’s much easier to use a P/E ratio than explain a NPV analysis. That’s why you see the P/E ratio in a number of my stock analysis. I don’t get paid for doing stock analysis; I do it because I fucking like it and also because I hope to get exposure for my investing ability (which is currently unproven). But as much as I like writing about stocks, I like actually researching stocks (and sometimes playing video games and binge watching TV shows) even more. That’s why I don’t write long, professional articles as it takes my time away from the things I really love. Thank you for reading. Take care and stay rational.    

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