Updated: Nov 17, 2020
In this article we will discuss the following topics:
P/E ratio as the simplest and most versatile multiplier
EV/EBITDA: advantages and disadvantages
DEBT and the multipliers that measure it
Understanding multipliers (financial ratios)
Multipliers (financial ratios) are derived economic indicators that measure a company's business and compare it with its competitors. The essence of the multipliers is that we bring the market valuation (share price) of the company and its business valuation (profit, revenue, etc.) to a single denominator.
Relatively speaking, we use 2 or more financial or stock-related metrics to get one ratio. This helps simplify the analysis to a sort of "one-number score." The biggest benefit of multipliers is that they are easy to assess, understand, and compare across several companies or across the whole industry.
Let me explain with an example:
The annual profit of company A - 1,000,000 dollars
The annual profit of company B - 10,000,000 dollars
The question: Which company is better to buy?
Here is another example:
Capitalization of company C - 1 billion dollars
Capitalization of company D - 5 billion dollars
Again, the same question: Which company is better to buy?
Actually, in both cases, there is no answer to the question, since there is not enough data to estimate - in the first example, we do not know the purchase price, in the second, business indicators: profit. etc. The mere fact that the profit of company B is greater than the profit of company A does not say anything.
But let's say the ratio between the company's capitalization and its profit is already enough for an assessment. We just choose the company with the best ratio.
This ratio is our multiplier. And there are many such various ratios (capitalization/profit, capitalization/revenue, etc.) - each of them is a separate multiplier.
This is where the valuation of companies is born, the understanding of whether a company is expensive or cheap.
After all, you can calculate a certain multiple for all companies in the same industry, and then calculate the arithmetic average.
And then it's simple - if the multiple of a particular company is higher (lower) than the industry average, then the company is overvalued (underestimated) by the market.
In the same way, you can easily compare companies with each other and at the same time you do not care if company A is 100 times more in capitalization than company B - the multipliers are brought to a single denominator.
P/E (Price-to-Earnings) multiplier (Pros and Cons):
The P/E multiplier is where everyone usually starts as this is one of the most popular multipliers. And this is why:
1. P/E is simple
P/E = Capitalization / Net Income. Everything is really simple - it is unambiguously clear what capitalization is and what is net profit. It is very difficult to make a mistake when calculating it.
2. P/E is universal
P / E can be calculated for any company, regardless of its type of business. This is a really useful property since companies in the financial sector (banks, management companies) have different reporting from companies in the real sector and a number of multipliers are not applicable to them. P / E is applicable to every company.
3. P/E can be used when the company is at a loss
P/E can be calculated in any case, even if the company has a loss. In this case, P/E is marked as ‘neg.’, Which clearly tells us that the company is at a loss. There can be no other connotations here (capitalization cannot be negative, after all).
4. P/E is clear
Another important factor is that the P/E ratio is logical and understandable to any person. We divide the entire value of the company (capitalization) by its annual profit and get the number of years for which the company's business will pay for itself.
The easiest way to understand the meaning is to imagine yourself as a business buyer. Let's say you want to buy a gas pump. This is a ready-made business that brings 1 million dollars of profit every year. The owner wants to sell it to you for 5 million dollars. You immediately figured in your mind that you would recover your money in 5 years if you bought the company. Thus, 5 is our P/E ratio that can be calculated as:
5 = 5 million (capitalization) / 1 million (profit).
5. The same number is used to value the whole company and just 1 share of it.
P/E ratio can be calculated for the whole company or just for 1 share. In both cases, the ratio will be the same. You can either calculate it by dividing total company capitalization by its total annual profit or by dividing the price of 1 share by annual EPS (earnings-per-share). The result will be the same.
P/E ratio shortcomings:
1. P/E looks only at the surface, not digging into details.
P/E ratio by itself is not enough to make a decision. The key component of the ratio is net profit which can be manipulated. It can be affected by amendments that are not related to the operating business, distorting the ratio (for example, fines or, on the contrary, payments from the insurance company, tax credits, one-time write-offs which have nothing to do with the business, but affect P/E)
2. P/E doesn't know everything
Sometimes the P/E can be large, not because the profit is small, but because the market values the company at a premium. For example, a company is showing excellent growth rates and could become a super-giant. Everyone, hoping for huge growth, wants to buy stocks. This pushes the stock price and the overall company capitalization grows. This results in an increase in P/E. But this does not mean that the company is bad, on the contrary, it is so good that the market is ready to overpay for it.
On the other hand, P/E may be small for a reason. For example, the company may be operating in a depressed industry with declining revenues. So, eventually, its profits are expected to decline which will result in a growth in its P/E (if capitalization stays the same). Or the company may be operating in a risky industry. For example, airline companies usually trade at lower P/E ratios and there is a reason for that: every few years airline companies engage in pricing wars with many of them going out of business. There are a lot of other factors that may impact sentiment for the company resulting in a low P/E, so if you do see a company with low P/E do make sure to double-check; there may be an underlying reason for that.
EV / EBITDA Multiplier: Advantages and Disadvantages
We said that P/E is a basic, simple and understandable assessment of a business, which at the same time has drawbacks, for example, many adjustments not related to the actual business operations can be made to the income statements. There is another drawback from the same series:
The capitalization of a company may differ from its real value.
Let's take our gas pump example that we can buy for 5 million dollars. Imagine you bought it, but it turned out that the company has 2 million dollars in debt and you need to repay this debt. It turns out that the real price you pay for the company is now not 5 million, but 5 + 2 = 7 million dollars. This is where the EV/EBITDA ratio comes in, which accounts for the P/E ratio shortcomings.
EV / EBITDA = fair P/E
EV - fair value (fair P)
EBITDA - fair profit (fair E)
EV = capitalization + debt - cash.
Debt comes with “+”, because it increases the value of the company for us (we will have to pay more), and money comes with “-“, because they reduce our cost. Both debt and cash can be found in the balance sheet of the company.
Let's say company A capitalization of 100 million dollars, its debt is $10 million, and its cash on hand is $3 million, then EV = 100 + 10 -3 = 107 million dollars.
EBITDA - Earnings Before Interest, Taxes, Depreciation, Amortization
The point of calculating EBITDA is precisely to remove all profit adjustments that are not related to the business itself.
Company A is located in the United States and pays 21% income tax
Company B is located in Canada and pays 15% income tax
It turns out that these companies are not very fair to compare in terms of P/E, since the former can bring more operating profit, but have a lower net profit, etc. As investors, we want to evaluate the business itself. Here EBITDA helps us in this, excluding these amendments.
Just to note EV and EBITDA are not the financial ratios themselves. They are the 2 metrics expressed in dollars that go into the calculation of the EV/EBITDA ratio.
Disadvantages of EV/EBITDA ratio
1. Is not good for all companies
EV / EBITDA is not applicable to companies in the financial sector, since the concept of debt in their reporting has a completely different meaning.
What I mean here is that a negative EV / EBITDA will not answer the question of what is happening in the company. Both the numerator and denominator in the calculation formula can be negative. Moreover, both of them can turn out to be negative, and then the result will turn out to be positive.
If you see a negative P/E, you know that the company is at a loss. If you see negative EV / EBITDA, you don't have a quick answer. You have to look at the actual numbers for EV and EBITDA to figure out if the company is profitable or not.
3. Questions to the technique itself
"Does management think the tooth fairy pays for capital expenditures?" Warren Buffett.
Here's what Buffett, one of the critics of EBITDA, tells us. His critics relate to the fact that EBITDA does not take into account depreciation. For example:
If the company spent 90 million dollars to purchase the new computers for its employees and decides to write off these expenses in the next three years in a linear way, then in the first year the indicator "expenses" will take into account a third of the real costs of buying computers - 30 million dollars. This will reduce profit for these 3 years. In other words, EBITDA overstates a company’s cash flow by not taking a charge for CAPEX (note: Capital Expenditures) and working capital while the other common method of simply adding depreciation back to net income also is inaccurate – adding back depreciation without any adjustment for a recurring capital expenditure paints the false picture of a company
Company debt and the multipliers that measure it
Now let's talk about companies' liabilities, debt, net debt, and the NetDebt/EBITDA multiple.
First, let's define that the company has obligations and has debt. You can find both on the balance sheet of the company. And they are not the same thing.
Has the company performed services to clients yet? It's a commitment. Didn't pay your salary? It's a commitment. These are obligations/commitments that are still part of the company's liabilities.
But if (and only if) the company took out a loan and must repay it - this is a debt! The key difference here is that the company has to pay interest on these debt obligations.
The difference between debt and net debt is the amount of money we have in our accounts. Let's say we owe 100 dollars, but we have 50 dollars in our pocket. Our debt is 100 dollars, and our net debt is 50 dollars.
Debt and liabilities are divided into short-term and long-term. Therefore, the final formula for net debt is:
Net debt = Short-term loans and borrowings + long-term loans and borrowings - cash and equivalents
Interestingly to note, a negative value of net debt is considered a negative indicator by investors. The absence of debt (excess of cash and liquid assets over debts) suggests that the company is using money inefficiently because the use of borrowed funds allows for production growth (the effect of financial leverage). The idea behind each business is to borrow money, invest in their business, and make a return on that borrowed money, repay the debt, and keep the profits to reinvest. Lack of debt may mean the company's management does not see an opportunity to grow the company further which is a bad sign for long-term investors.
NetDebt / EBITDA Multiplier
This multiplier shows the ratio of net debt to EBITDA. It tells the investor how many years it takes the company's business to pay off the entire debt. A NetDebt / EBITDA ratio above 3 indicates a high debt burden. And the higher the indicator, the worse.
ROA (Return On Assets) - Return on Assets
ROE (Return On Equity) - Return on Equity
ROS (Return On Sales) - Revenue profitability
ROIC (Return On Invested Capital) - Return On Invested Capital
As you can see, these multiples measure profitability (business performance). In each of the multipliers, we look at the company's profit relative to other indicators/financial metrics.
What part of the profit is from the proceeds?
And what part of the profit is from equity?
Is the profit derived from assets?
With these questions, we want to understand: how effective is the company's using its capital, assets, how much profit it generates from sales?
Let's look at an example:
There are 2 banks with the same profit. Bank A makes a profit, having equity capital of 100 million dollars, and the second generates the same profit, having equity capital of 200 million dollars.
So, it turns out that the return on equity (ROE) of bank A is 2 times higher.
Profitability is a relative measure of economic efficiency. Profitability reflects the degree of efficiency in the use of assets, labor, capital, and other resources. Profitability multiples are especially useful when analyzing banks. This is because many cost multiples are not applicable to banks.
1. It is better to have at hand not only the actual multipliers but also the dynamics of their change in the historical period. One inadequate report can change the whole picture, while in dynamics you will see the real state of affairs.
2. It is necessary to evaluate the company in a comprehensive manner at once using several multipliers, and not one by one.
3. It is better to consider the multipliers of different companies according to their identical formulas than to take the values already calculated by the companies themselves. So you will bring all the data to a single denominator. Then, they can be compared with each other, and you will know how all these numbers turned out.