EV/EBITDA倍数意味着什么？

What Does an EV/EBITDA Multiple Mean?

Valuing companies is a big part of what we We find that investors commonly employ

do. Whether debt or equity, public or private, EV/EBITDA without being fully aware of the we need to understand value to assess if a underlying economic assumptions the multiple price presents an opportunity to create alpha. implies.

There is a rich literature on valuation, which is The spread between return on invested straightforward in theory but often capital and the cost of capital, along with challenging in practice. A business is worth earnings growth, are the primary determinants the present value of future free cash flows, but of a warranted EV/EBITDA multiple. We seek to forecasting the magnitude, timing, and apply multiples intelligently, rigorously, and riskiness of cash flow streams is inherently consistently.

difficult. As a result, most investors rely on shorthands for the valuation process. In this report, Michael’s treatment of EV/EBITDA goes from theory to practice to The EV/EBITDA multiple is among the most empirical evidence. As always, we would be popular techniques to value businesses. pleased to discuss specific examples of how Applied properly, EV/EBITDA can be a very we apply these principles.

helpful tool. But a naive use of EV/EBITDA leads to valuation mistakes.

Andrew Feldstein Chief Investment Officer September 13, 2018

BLUEMOUNTAIN INVESTMENT RESEARCH / SEPTEMBER 13, 2018

What Does an EV/EBITDA Multiple Mean?

This report is about the EV/EBITDA multiple, or enterprise value divided Michael J. Mauboussin Director of Research [email protected] by earnings before interest, taxes, depreciation, and amortization. It is a widely used and misused approach to valuation. We put EV/EBITDA in historical context, define terms, and describe some of the limitations of using the multiple. We then show how to relate EV/EBITDA multiples to sound theory. We continue by sharing empirical findings to demonstrate that the market reflects the economic drivers of value and showing how multiples of EV/EBITDA and price-to-earnings relate to one another. We finish with specific recommendations for how to use EV/EBITDA multiples as effectively as possible.

Here is the bottom line: A naive use of EV/EBITDA leads to valuation mistakes. The warranted multiple is predominantly a function of value creation, growth, and risk. Companies with multiples above the warranted level underperform those with multiples below their warranted level.1 Thoughtful investors take the time to understand the assumptions that are embedded in the multiples they use.

A Brief History of Valuation and emphasis on dividends was well placed, as the yields on stocks remained consistently above the Emergence of EBITDA those of investment-grade bonds until 1958. That Equity valuation techniques have evolved over stocks came to yield less than bonds appeared time. One hundred years ago, investors valued heretical to market veterans of the day, who stocks on metrics such as dividend yield, the noted that stocks are riskier than bonds and price-to-earnings multiple, and the price-to-book hence should yield more. But dividend yields value multiple.2 For example, Benjamin Graham remained below bond yields until a crisis hit the and David Dodd’s classic text from 1934, Security financial markets 50 years later.6 Analysis, suggests that the dividend rate and “Dividend Policy, Growth, and the Valuation of record, earning power, and asset value are the Shares,” a paper published in 1961 by the finance basis for common stock valuation.3 In 1938, John professors Merton Miller and Franco Modigliani, Burr Williams formalized the dividend discount ushered in the modern era of valuation.7 They model in The Theory of Investment Value.4 Myron asked a fundamental question: What does the Gordon’s growth model, described in 1959, equity market discount? They considered four showed how to capitalize dividend growth.5 The possibilities, including cash flow, current earnings

plus future opportunities to create value, the

stream of dividends, and the stream of earnings.

Their conclusion was a surprise. Considered correctly, these all collapse into the same model.

The value of a stock is the present value of future free cash flows. This is what you learned if you studied finance in school.

But there has always been a gap between theory and practice. The main reason is that the discounted cash flow (DCF) model, while analytically sound, demands a number of judgments. The model’s output varies greatly based on the inputs. There are ways to deal with this challenge, but most practitioners avoid a DCF model altogether and instead use shorthands in the form of multiples. 8 It is crucial to acknowledge that multiples are not valuation but rather a summary of the valuation process. This distinction is a point of emphasis throughout this report.

A recent survey found that the two most popular multiples are price-to-earnings (P/E) and EV/EBITDA. The survey of nearly 2,000 investors found 93 percent of them use multiples, with 88 percent applying P/E and 77 percent EV/EBITDA. 9 The trend toward EV/EBITDA is not limited to investors. Researchers analyzed tens of thousands of annual reports and earnings releases for companies in the S&P 1500 for the decade ended 2016 and found that roughly 15 percent of them highlight EBITDA. Companies that emphasize EBITDA are on average smaller, more leveraged, more capital intensive, and less profitable than their peers. 10 The use of EBITDA is most popular in the entertainment, healthcare, telecommunications, and publishing industries. 11 Investors have used P/E multiples for a long time, but EV/EBITDA is a relatively recent valuation proxy. Will Thorndike, an investor and the author of The Outsiders, credits John Malone with introducing the term EBITDA. 12 Malone is a media mogul who made his fortune with investments in Tele-Communications, Inc. and Liberty Media Corporation, among other companies. Malone joined Tele-Communications, Inc. in 1973. Exhibit 1 shows the popularity of earnings per share and EBITDA in books that Google scans. References to earnings have been roughly stable for the last 40 years, but EBITDA has trended up steadily since it burst onto the valuation scene in the late 1980s. Early enthusiasts cited three reasons to use EBITDA rather than a more traditional metric. First, it is Exhibit 1: References to “EBITDA” and “Earnings Per Share” in Books, 1960-2008

0.00007 Earnings Per Share

Source: Google Ngram.

a broad measure of cash flow and indicates the capacity to invest and service debt. Second, it can be relevant for companies losing money because EBITDA is often positive even when earnings are negative. Finally, EBITDA appears more applicable for companies that seek to minimize taxes by adding debt, as interest expense is tax deductible. 13 Partly reflecting these reasons, EV/EBITDA became the main metric investors used to evaluate leveraged buyouts in the 1980s and it remains the primary way to value private equity deals.

Most analysts who work for investment banks early in their careers learn to rely predominantly on EV/EBITDA for valuation. They commonly move on to positions at private equity firms or hedge funds, bringing their valuation practices with them. 14 As alternative asset classes have grown relative to more traditional ones, so too has the application of EBITDA.

EBITDA multiples even appear frequently in the work of analysts who use a DCF model. Most DCF models have an explicit forecast period and a residual, or terminal, value to reflect the cash flows beyond the explicit period. The vast majority of private equity firms, for example, model explicit cash flows for five years and many use EBITDA multiples to estimate the terminal value. 15 Since the terminal value can make up 70 percent or more of the enterprise value, the explicit cash flows are mostly just the path to the main event— the decision of what multiple to apply to the last year of cash flow. 16 There are effective methods to deal with this analytical challenge as well, but few investors use them. 17

Definition s of Terms Limitations of EBITDA Before proceeding, let’s take a moment to define There is evidence that the EV/EBITDA multiple can terms. Enterprise value is the value of the core be helpful for investors. For example, the operations less nonoperating assets, such as EV/EBITDA multiple is a useful quantitative factor excess cash and nonconsolidated subsidiaries. and explains market valuations and predicts Enterprise value is also equal to short- and long- stock returns better than operating profit does.20 term debt, debt equivalents, and other claims But deep skepticism remains about its utility, (e.g., restricted stock units), less excess cash and especially in the value investing community, nonoperating assets, plus equity value.

because of what it fails to reflect. For example, EBITDA is operating profit (earnings before interest Warren Buffett, chairman and chief executive and taxes, or EBIT) plus depreciation and officer of Berkshire Hathaway, had this to say amortization expenses (DA). EBITDA does not about EBITDA at Berkshire’s annual shareholder reflect interest expense, taxes, or investments meeting in 2003:21 required to maintain or grow the business, Any management that doesn’t regard including changes in net working capital, capital depreciation as an expense is living in a expenditures, and acquisitions. Because EBITDA dream world. But of course, they are can be distributed to all claimholders, it is encouraged to do that by investment appropriate to compare it to enterprise value.

bankers who talk to them about EBITDA. And EBITDA is not subject to generally accepted certain people have built fortunes on accounting principles (GAAP), but the straight misleading investors by convincing them that calculation is based on figures that do adhere to EBITDA was a big deal.

GAAP. That EBITDA is a non-GAAP sum creates a I get these people that want to send me great deal of flexibility and encourages books with EBITDA in it. And I just tell ‘em, “I’ll companies to take some liberty in how they look at that figure when you tell me you’ll define the term. The most common of these is make all of the future capital expenditures for adjusted EBITDA, which removes non-recurring me.”

items such as restructuring charges and impairment costs and adds items such as Berkshire Hathaway’s vice chairman, Charlie acquisition synergies and other anticipated cost Munger, added a more colorful quip: savings. For example, companies acquired by I think you’d understand any presentation private equity firms that issued debt made using the word “EBITDA” if every time you saw adjustments that increased their EBITDA by an that word, you just substituted the phrase average of 13.7 percent in 2017, up from 9.6 “bullshit earnings.”

percent in 2016. The industries with the largest adjustments include healthcare, gaming, and Seth Klarman, the founder, chief executive, and technology.18 portfolio manager of the very successful value investing firm The Baupost Group, shares a similar Jason Zweig, a journalist at the Wall Street sentiment in his book Margin of Safety:22 Journal, ticks off some of the other flavors he has seen: EBITDAC, EBITDAO, EBITDAP, EBITDAR, It is not clear why investors suddenly came to EBITDARE, EBITDAS or EBITDASC, EBITDAX, and accept EBITDA as a measure of corporate “community-adjusted EBITDA,” which, he reports, cash flow. EBIT did not accurately measure excludes such basic costs of doing business as the cash flow from a company‘s ongoing marketing, development, and administrative income stream. Adding back 100 percent of expenses.19 depreciation and amortization to arrive at EBITDA rendered it even less meaningful.

Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.

There are at least three pitfalls to using EV/EBITDA. The first is that there is not a proper reckoning for the investment needs of the business, the concern that Buffett and Klarman express. Exhibit 2 shows the adjustments necessary to go from EBITDA to unlevered free cash flow. Both EBITDA and unlevered free cash flow are financing neutral, which means their values are impervious to the company’s capital structure. You can compare both figures to enterprise value because they exclude explicit financing costs, although EBITDA does not consider investment needs and taxes while free cash flow does.

The potential danger in using EBITDA is that it understates the capital intensity of the business. As a consequence, EBITDA overstates the amount of cash a company can distribute while running the operations appropriately. While there is a well-placed focus on capital expenditures and depreciation, working capital changes and acquisitions can also be vital.

Exhibit 2: From EBITDA to Unlevered Free Cash Flow

EBITDA (Earnings before interest, taxes, depreciation, and amortization)

– Depreciation

= EBITA (Earnings before interest, taxes, and amortization)

– Cash taxes

= NOPAT (Net operating profit after taxes)

– Investments

• Change in net working capital

• Capital expenditures – depreciation

• Acquisitions – divestitures

= Unlevered free cash flow

Source: BlueMountain Capital Management.

The second pitfall is that multiples, including EV/EBITDA, do not explicitly reflect risk. We are interested here in business risk. Operating leverage, the percentage change in operating profit as a function of the percentage change in sales, is a suitable measure of business risk. For instance, the operating profit of a business with high operating leverage is very sensitive to changes in sales, whereas sales changes have a more muted effect on the operating profit for a business with low operating leverage.

The final problem has to do with taxes. Two companies with the same EBITDA and capital structures may pay taxes at dissimilar rates. As a result, the EV/EBITDA multiples will be justifiably different. Essentially, the shortcomings of EBITDA reflect the items that reconcile EBITDA to free cash flow in exhibit 2.

Relates to enterprise value

Capital intensity

Relates to enterprise value

From Theory to Practice –Part I

In their pathbreaking paper on valuation, Miller and Modigliani provide a formula that is core to understanding value. They say:

The value of the firm = steady-state value + future value creation Over the last 60 years, roughly two-thirds of the value of the S&P 500 price was attributable to steady-state value and the other one-third to future value creation. Both pieces are important. 23 Appendix A discusses how to model businesses with declining cash flows.

Here’s an intuitive way to think about it. 24 Say you owned 10 mature and profitable restaurants.

Assuming the current profits persist for the foreseeable future, those restaurants are the foundation for the steady-state value. Now consider the possibility of opening new restaurants that are worth more than they cost to build. That is future value creation.

The important point is that future value creation is based on three elements: finding projects that generate a positive spread between the return on invested capital (ROIC) and the weighted average cost of capital (WACC), how much you can invest in those projects, and how long you can find those projects in a competitive world.

Note that the latter elements, how much and how long, only create value if there is a positive spread between ROIC and WACC. If the spread is zero, the second term on the right side of the equation collapses to zero. Indeed, the second term can be negative if the investments fail to earn the cost of capital.

This illuminates the critical lesson that you have to start with the spread between ROIC and WACC.

Calculating ROIC and WACC correctly is a prerequisite to doing this analysis appropriately.

Growth creates a lot of value only when the spread is positive and large, has no effect when the spread is zero, and destroys value when the spread is negative. Too many executives and investors focus on growth without recognizing the need for a positive spread in order to create value.

We will apply these principles to EV/EBITDA multiples in a moment, but we can start with a simpler example to make the concepts concrete.

The body of exhibit 3 is populated with the Exhibit 3: Warranted P/E Multiple for Various Assumptions about ROIC and Growth

Source: BlueMountain Capital Management.

Note: Assume all equity financed; 8% cost of capital; 15- year forecast period.

theoretical P/E’s that are the result of various assumptions about return on invested capital, which you see across the top, and earnings growth rates, which you see down the left side. 25 For simplicity, we have assumed an all-equity financed business and a cost of capital of 8 percent, but as we will see shortly these specific assumptions are not critical to the general conclusions we can draw.

Three points are clear upon examination of the P/E’s. The first is if a company earns exactly its cost of capital—eight percent in this case— growth doesn’t matter. The company is on an economic treadmill, so speeding up or slowing down doesn’t matter. The second term on the right side of the Miller and Modigliani equation collapses to zero, and all we can count on is the steady-state value.

When returns are above the cost of capital, growth becomes extremely valuable. For example, when the ROIC is 24 percent, going from 6 to 10 percent growth lifts the warranted P/E ratio from 19 to 26. Companies with a high ROIC are very sensitive to changes in expected growth rates.

If a company is investing at a rate below the cost of capital, growth is bad. The faster it grows, the more wealth it destroys. You see this when a company announces an acquisition that adds to earnings per share but reduces market capitalization. The market renders its judgment on the deal’s economic value.

Our task now is to translate these core principles into EV/EBITDA multiples.

From Theory to Practice –Part II

In order to go from theory to the relevant EV/EBITDA multiples, we need to discuss three interrelated topics: capital intensity, return on invested capital, and leverage.

Let’s start with capital intensity. At the core of Buffett’s and Klarman’s concerns is the fact that EBITDA fails to acknowledge a business’s capital needs. We can address this topic empirically through a detailed study of the capital allocation practices of the top 1,500 industrial companies in the U.S. over the last 40 years. 26 There are three major forms of investment that show up on the balance sheet: changes in net working capital, capital expenditures minus depreciation, and acquisitions minus divestitures. Overall, net working capital does not demand a lot of investment. Net working capital, excluding cash, has averaged roughly $220 billion for the top 1,500 industrial companies in the U.S. since 1980. That said, working capital needs vary a great deal by sector.

It is useful to analyze a company’s cash conversion cycle (CCC), a calculation of how long it takes a company to collect on the sale of inventory. The CCC equals days in sales outstanding (DSO) plus days in inventory outstanding (DIO) less days in payables outstanding (DPO). Good working capital management is associated with high returns on invested capital.

Capital expenditures are a significant investment over time, second only to acquisitions in total dollars spent. Analysts commonly use depreciation as a proxy for maintenance capital expenditures and fail to consider the investment necessary to support value-creating growth.

Capital expenditures have averaged about 1.5 times depreciation for the top 1,500 industrial companies in the U.S. over the past 4 decades.

Acquisitions are by far the largest source of investment. Here’s a common analytical mistake: Investors extrapolate a historical EBITDA growth rate that is in part the result of acquisitions but don’t consider appropriate investments in their forecasts. As a result, they underestimate the capital required to achieve that growth. For most companies, it is proper to forecast organic growth only and to assume that acquisitions are likely to have little impact on shareholder value. The global economy continues to shift from tangible to intangible assets. 27 Companies generally expense investments in intangible assets, including brands and acquired customers, which is reflected in EBIT. But when an acquirer buys a target, it must reflect tangible and intangible assets, as well as goodwill, on its balance sheet. The acquirer must then amortize the intangible assets. As a result, the mix of “DA” in EBITDA has been shifting from depreciation to amortization. 28 Exhibit 4 shows that amortization was one-half of 1 percent of depreciation and amortization in 1980 and is now about 22 percent.

The pattern in exhibit 4 reflects two major revisions in accounting standards for business combinations. The first, implemented in 2002, eliminated a method called “pooling of interests,” which allowed companies to simply combine their balance sheets and, as a result, sidestep the need to reflect intangible assets on the balance sheet.

The accounting rule also ended the amortization of goodwill for those companies using the purchase method. The purchase method required the buyer to record the difference between the seller’s market value and book value as goodwill on its balance sheet. This goodwill was then amortized for up to 40 years. The implementation of the standard led to a sharp drop in amortization that you see in the middle of the exhibit.

Exhibit 4: Amortization As a Percentage of

Source: Credit Suisse HOLT and Bloomberg.

Note: Top 1,500 U.S. industrial companies.

The second revision, introduced in 2007, changed The top panel shows the median values and the acquisition accounting and served to increase bottom panel shows the aggregate values. the amount of intangible assets relative to Appendix B shows the same analysis by industry. goodwill. The sharp rise in amortization is a For some sectors, including consumer staples and consequence of these accounting changes, information technology, EBIT is about three-rising investment in intangible assets, and a robust quarters of EBITDA. For other sectors, such as market for mergers and acquisitions.

telecommunication services and energy, DA is The amount of depreciation and amortization a the larger component of EBITDA. Use of EBITDA company recognizes is a function of its capital creates a risk of understating capital intensity for intensity, the asset lives it assumes, and its companies with high EBITDA Depreciation acquisitiveness. One useful measure of capital Factors.

intensity is the relationship between EBIT and DA.

The second topic that provides a bridge from EBIT is a higher percentage of EBITDA for capital-theory to practice is the significance of ROIC. The light businesses than for capital-intensive critical concept is return on incremental invested businesses.

capital (ROIIC). ROIIC compares the change in Exhibit 5 shows the contributions of EBIT and DA to NOPAT in a given year to the investments made total EBITDA by sector, as well as the EBITDA in the prior year. For example, if a company’s Depreciation Factor, defined as EBITDA/EBIT.29 The NOPAT increases $200 this year and it invested universe is the Russell 3000 excluding companies $1,000 last year, the ROIIC is 20 percent in the financial services and real estate sectors. ($200/$1,000).30

Exhibit 5: Contributions of EBIT and DA to Total EBITDA by Sector

Source: Bloomberg.

Note: Data for calendar year 2017; Russell 3000 as of May 31, 2018 excluding financial services and real estate sectors and companies with negative EBIT.

When ROIIC is high, a company can achieve its growth targets while investing a modest amount.

High ROIIC businesses are more valuable than low ROIIC businesses because they need to invest less for a given rate of growth. Less spending on investment means more money for investors.

As a result of this, we should expect that industries with low EBITDA Depreciation Factors have higher ROICs than industries with high EBITDA Depreciation Factors. Exhibit 6 shows that this relationship generally holds true. This aligns with your intuition as a businessperson that it is very difficult to generate high ROICs in capital intensive industries.

The final topic is leverage. In paper published in 1958, Franco Modigliani and Merton Miller showed that the value of a firm is independent of its capital structure. 31 But the invariance principle does not hold if different capital structures give rise to different tax liabilities. In plain terms, greater debt means that more of a company’s cash flows go to its claimholders and less go to the government.

The standard way to reflect the value of income shielded by interest expense is in the cost of capital. For our discussion, the central point is that leverage affects the WACC and not the ROIC.

Exhibit 6: Relationship between EBITDA Depreciation Factor and ROIC

Source: Bloomberg.

Note: Aggregated data for industries; calendar year 2017; universe is Russell 3000 as of May 31, 2018 excluding financial services and real estate sectors and companies with negative EBIT.

The pecking order theory of capital structure says that companies access capital first through internally generated cash, next by raising debt, and finally by raising equity. 32 Capital intensive industries tend to use more debt financing than capital light industries because they cannot fund their growth solely through internally generated cash.

But the relationship between capital structure and ROIC is a little more complicated because high ROIC businesses can increase leverage, for example by doing a leveraged buyout, but low-ROIC businesses cannot readily delever.

Businesses with high EBITDA Depreciation Factors tend to have more debt than those with low factors, but the correlation is not as strong as it is for ROIC.

We are now ready for the payoff, exhibit 7, which shows the warranted EV/EBITDA multiples assuming EBITDA Depreciation Factors of 1.2, 1.5, and 1.8. In each case, we have held the debt-tototal capital ratio constant at 20 percent and the cost of capital at 7.2 percent. 33 A couple observations are in order.

At first blush, it may not be obvious why companies with the same growth, ROIIC, and cost of capital would have different EV/EBITDA multiples, even considering the range of EBITDA Depreciation Factors. Indeed, the corporate values are the same for the matching set of assumptions. Here’s the way to think about it. “Earnings” on the vertical axis is net operating profit after tax (NOPAT), a term we saw in exhibit

2. Companies with low EBITDA Depreciation Factors don’t need to generate as much EBITDA as companies with high EBITDA Depreciation Factors to deliver the same amount of NOPAT.

Here’s an example. Assuming a 25 percent tax rate, a company has to have EBIT of $133.3 to generate $100 in NOPAT whether its EBITDA Depreciation Factor is low or high. For a company with a 1.2 factor, depreciation and amortization is $26.7, which means that EBITDA is $160 ($160/$133.3 = 1.2). For a company with a 1.8 factor, depreciation and amortization is $133.3, which means that EBITDA is $240 ($240/$133.3 = 1.8). If you assume that incremental returns are equal to the cost of capital for both, their value is $1,389 ($100/7.2%).

The low factor company is worth 8.7 times current EBITDA and the high factor company is worth 5.8 times.

Companies with low EBITDA Depreciation Factors ROIIC is equal to the cost of capital, and growth get higher multiples than companies with high amplifies the good when returns are attractive EBITDA Depreciation Factors holding other value and amplifies the bad when they are drivers equal. unattractive. Companies that focus solely on EBITDA growth without taking into consideration Second, the core concepts from exhibit 3 apply return on incremental invested capital are in exhibit 7 as well. Growth doesn’t matter if your headed for trouble.34

Exhibit 7: Relationship between EBITDA Depreciation Factor and ROIC

Depreciation factor = 1.2 (EBIT to EBITDA=83.3%)

Re turn on Inve ste d Ca pita l 0.0 4.0% 7.2% 8.0% 16.0% 24.0%

4.0% 5.5x 8.7x 9.1x 10.9x 11.5x

Depreciation factor = 1.5 (EBIT to EBITDA=66.7%) Re turn on Inve ste d Ca pita l 4.0% 7.2% 8.0% 16.0% 24.0%

4.0% 4.4x 6.9x 7.3x 8.7x 9.2x

Depreciation factor = 1.8 (EBIT to EBITDA=55.6%) Re turn on Inve ste d Ca pita l 4.0% 7.2% 8.0% 16.0% 24.0%

4.0% 3.7x 5.8x 6.1x 7.2x 7.6x

Source: BlueMountain Capital Management.

Note: Assumes a 20 percent debt-to-total capitalization ratio and a 15-year forecast period.

Empirical Results Theory is great, but it is also nice to know the core and fast growth; and the bottom left corner is low findings are corroborated by the stock market. ROIC and slow growth.

Exhibit 8 places the universe of the top 1,500 Our results are consistent with what the matrices industrial companies in the U.S. on a graph, with of warranted multiples suggest. The high ROIC expected return on capital minus the cost of and fast growing companies have the highest capital on the horizontal axis and expected median EV/EBITDA multiples at 13.3 times, EBITDA growth on the vertical axis. We then followed by high ROIC slow growth at 11.4 times. segregate the population into four quadrants.

Fittingly, the market assigns the low ROIC, fast The upper right corner is high ROIC and fast growth quadrant a multiple of 8.7 times, and the growth; the bottom right corner is high ROIC and low ROIC, slow growth quadrant the lowest slow growth; the upper left corner is low ROIC multiple at 8.4 times.

Exhibit 8: The Market Gets It: ROIC, Growth, and EV/EBITDA Multiples

Expected Return on Capital Minus Cost of Capital

Source: Based on Credit Suisse Corporate Insights, “Managing the multiple: Weighing growth against profitability,” First Quarter 2016.

Notes: As of July 29, 2018; top 1,500 U.S. industrial companies excluding those with negative EBITDA; scales are truncated for visual purposes; EBITDA growth is the consensus estimate for annualized EBITDA growth over the next three fiscal years; EV/EBITDA is the ratio of the current enterprise value to the consensus estimate for EBITDA in calendar year 2019; expected return on capital spread is Credit Suisse HOLT’s cash flow return on investment (CFROI) minus discount rate for the next fiscal year.

P/E versus EV/EBITDA

We saw that P/E and EV/EBITDA are two of the most popular valuation heuristics. Exhibit 9 shows that the correlation between the multiples is high (r = .79) for a large sample of companies. But there are instances when two companies have the same EV/EBITDA multiple and very different P/E multiples, or the same P/E multiple and very different EV/EBITDA multiples. Analysts who use one multiple versus the other or, more perniciously, select the multiple that makes their investment case risk coming to a faulty conclusion.

The core drivers of all multiples are incremental ROIC and growth. Two companies with the same prospects for ROIC and growth can have different relationships between P/E and EV/EBITDA because of dissimilar capital structures, different tax rates, and reckoning for unconsolidated businesses.

Exhibit 9: Correlation between EV/EBITDA and P/E

Source: Bloomberg.

Note: Top 1,500 U.S. industrial companies excluding those with negative EBITDA; as of August 1, 2018; winsorized at 1st and 99th percentiles; scales are truncated for visual purposes; the EV/EBITDA and P/E ratios are based on consensus estimates for calendar year 2019.

Assumed asset life is an example of an accounting choice that can affect multiples.

Imagine two competitors have to spend $1,000 for a machine that is vital to their operations. The first company assumes the machine will have an 8-year asset life and uses straight-line depreciation, creating an annual depreciation expense of $125. The second company assumes a 10-year asset life, generating an annual expense of $100. The earnings of the second company will be higher than those of the first even as the EBITDA is identical.

A company’s capital structure can also affect the P/E multiple. Consider the simple case of a debt-financed share buyback program, which serves to increase leverage by replacing equity with debt in the capital structure. The earnings per share impact of the buyback is a function of the P/E multiple and the after-tax cost of new debt. When the inverse of the P/E, E/P, is higher than the after-tax interest expense, a buyback adds to earnings per share. Assuming no change in price, this lowers the P/E. Note that a buyback’s impact on earnings per share, whether it adds to or detracts from the bottom line, is independent of whether it adds to or detracts from value.

Two companies with matching ROIC and growth prospects, accounting policies, and capital structures may still have different multiples as the result of a higher or lower tax rate. (Tax rates are also relevant for ROIC, but the effect goes beyond that.) Lower tax rates increase enterprise value and earnings but have no effect on EBITDA.

Finally, some companies have unconsolidated businesses or cross holdings that may factor into a calculation of enterprise value but can distort earnings or EBITDA. When comparing the multiples of companies, make sure you are looking at the operations on a consistent basis.

Recommendations for Action Within an investment firm, you might hear multiple of 10 times or higher lost money, someone say, “This is an 8 times EBITDA business,” and that for every dollar put into these or, “The comparable companies trade at 10 deals investors got only a tad more than times EBITDA.” Not a lot of thought is given to a dollar out.37 There is nothing magical what these multiples imply about future financial about 10 times. The essential point is performance and how the multiples may businesses have different warranted misspecify the nature of the investment. Investing multiples that are important to in credit or equity demands a thorough analysis understand as you buy and sell their of cash flows and an understanding of what securities.

those cash flows imply about value.

 Use of various valuation approaches can Truth be told, most analysts use a multiple to guide you toward a central tendency of assign a price to a company. Aswath value. Research in the forecasting Damodaran, a professor of finance at the Stern literature shows that combining forecasts School of Business at New York University and a derived from different methods can leading expert in valuation, offers the following: reduce error and yield more accurate predictions.38 There’s nothing wrong with pricing. But it’s not valuation. Valuation is about digging through  You don’t want your embedded a business, understanding the business, assumptions to be unmoored from the understanding its cash flows, growth, and risk, fundamental drivers of value. Before and then trying to attach a number to a applying an EV/EBITDA multiple, be sure business based on its value as a business. to consider the key drivers of value.39 Most people don’t do that. It’s not their job. While simple, the matrices in exhibit 7 can They price companies. So the biggest mistake serve as a sanity check for your valuation in valuation is mistaking pricing for work.

valuation.35  The vocal critics of EBITDA may be Based on this discussion, here are five ideas to overstating their case, but the risk of bear in mind: underestimating the capital required to grow is real. Make sure you consider  Evidence shows that buying a stock at a carefully what capital needs a company premium to its warranted multiple leads truly has to make sure that cash flow to poor excess returns and buying at a projections are not illusory.

discount leads to attractive excess returns.36 For example, Dan Rasmussen,  If you use EBITDA as the terminal value in founder and portfolio manager of a discounted cash flow model, use the Verdad Advisers, highlights analysis that average multiple over a cycle. You may suggests more than one-half of private introduce a substantial error if you rely on equity deals done at an EV/EBITDA end-of-period economic assumptions.40

Appendix A: Modeling Declining I ndustries Not all companies can maintain their current levels of net operating profit after tax. 41 For example, DVD, game, and video rental businesses and wired telecommunications carriers face secular decline.

In these instances, we need to modify the steady-state value with a variation of the Gordon growth model:

Modified steady-state value = Net operating profit after tax (1 + growth)

Cost of capital - growth

Take as an example a company that has $1,000 in NOPAT and an 8 percent cost of capital. The steady-state value is $12,500 ($1,000/.08). Let’s now assume that the company’s profit will decline 10 percent per year in perpetuity.

We add a negative value for growth in the numerator, which reduces NOPAT. We also subtract a negative in the denominator, which increases the discount rate. We calculate the value as follows:

Modified steady-state value = $1,000 (1 + -.10) = $1,000(.90) = $900 = $5,000 .08 - -.10 0.18 0.18

Assuming this rate of decline is accurate and the market prices it properly, the steady-state multiple is 5.0 times ($5,000/$1,000).

Appendix B: Breakdown of EBIT and DA by Industry

Exhibit 10: Contributions of EBIT and DA to Total EBITDA for the Most Recent Year

Source: Bloomberg.

Note: Data for calendar year 2017; Russell 3000 as of May 31, 2018 excluding financial services and real estate sectors and companies with negative EBIT.

Endnotes 1 Jiyoun An, Sanjeev Bhojraj, and David T. Ng, “Warranted Multiples and Future Returns,” Journal of

Accounting, Auditing, and Finance, Vol. 25, No. 10, April 2010, 143-169.

2 Samuel Eliot Gould, Stock Growth and Discount Tables (Boston, MA: Financial Publishing Company,

1931).

3 Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill Book Company, 1934). 4 John Burr Williams, The Theory of Investment Value (Cambridge, MA: Harvard University Press, 1938). 5 M. J. Gordon, “Dividends, Earnings, and Stock Prices,” Review of Economics and Statistics, Vol. 41, No.

2, Part 1, May, 1959, 99-105.

6 Peter L. Bernstein, “Two Little-Noted Features Of The Markets And The Economy,” Economics &

Portfolio Strategy, November 3, 2008.

7 Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,”

Journal of Business, Vol. 34, No. 4, October 1961, 411-433.

8 Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better

Returns (Boston, MA: Harvard Business School Press, 2001).

9 Frank J. Fabozzi, Sergio M. Focardi, and Caroline Jonas, “Equity Valuation: Science, Art, or Craft?”

CFA Institute Research Foundation, 2017. For similar findings, see Stanley Block, “Methods of Valuation: Myths vs. Reality,” Journal of Investing, Vol. 19, No. 4, Winter 2010, 7-14 and Kjell G. Nyborg and Lilia Mukhlynina, “Survey of Valuation Professionals: Valuation Techniques in Practice,” Swiss Finance Institute, June 2016.

10 Arnt Verriest, Jan Bouwens, and Ties De Kok, “The Prevalence and Validity of EBITDA as a

Performance Measure,” Working Paper, June 2018.

11 Oded Rozenbaum, “EBITDA and Managers’ Investment and Leverage Choices,” Contemporary

Accounting Research, forthcoming.

12 William Thorndike, The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for

Success (Boston, MA: Harvard Business Review Press, 2012), 91. Malone joined Tele-Communications, Inc. in 1973.

13 Not all companies can take all of their interest expense as a deduction from taxes. For companies

with sales of $25 million or more, the recent Tax Cuts and Jobs Act of 2017 limits the interest deduction at 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) through 2021. Based on the figures for 2017, this would affect about 15 percent of the Russell 3000, excluding companies in the financial services and real estate sectors. From 2022 on, interest deduction will be capped at 30 percent of earnings before interest and taxes (EBIT). Based on the figures for 2017, this would affect about 20 percent of the Russell 3000, excluding companies in the financial services and real estate sectors.

14 Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, Leveraged Buyouts, and

Mergers & Acquisitions, Second Edition (Hoboken, NJ: John Wiley & Sons, 2013).

15 Paul Gompers, Steven N. Kaplan, and Vladimir Mukharlyamov, “What Do Private Equity Firms Say

They Do?” Harvard Business School Working Paper 15-081, April 2015.

16 Doron Nissim, “Terminal Value,” Columbia Business School Research Paper No. 18-12, January 4, 2018

and Edward Bodmer, Corporate and Project Finance Modeling: Theory and Practice (Hoboken, NJ: John Wiley & Sons, 2015), 445-451.

17 David A. Holland, “An Improved Method for Valuing Mature Companies and Estimating Terminal

Value,” Journal of Applied Corporate Finance, Vol. 30, No. 1, Winter 2018, 70-77.

18 Martin Hallmark, Frederic Duranson, Iker Ballestero Barrutia, and Richard Etheridge, “EBITDA

Adjustment on the Rise but Fewer Will Be Achieved,” Moody’s Investors Service, June 27, 2018. 19 Jason Zweig, “How Companies Use the Latest Profits Fad to Fool You,” Wall Street Journal, June 1,

2018. Per Zweig, “EBITDAC (with a change in acquisition costs used by insurers); EBITDAO (with option expense, a cost of paying management); EBITDAP (pension and other retirement benefits); EBITDAR (the costs of leasing real estate or airplanes, depending on the industry); EBITDARE (losses, gains and other adjustments on real estate); EBITDAS or EBITDASC (stock-based pay for management); and EBITDAX (exploration costs for oil-and-gas companies).”

20 For example, see Tim Loughran and Jay W. Wellman, “New Evidence on the Relation between the

Enterprise Multiple and Average Stock Returns,” Journal of Financial and Quantitative Analysis, Vol. 46, No. 6, December 2011, 1629-1650; Wesley R. Gray and Jack Vogel, “Analyzing Valuation Measures: A Performance Horse Race over the Past 40 Years,” Journal of Portfolio Management, Vol. 39, No. 1, Fall 2012, 112-121; and Doron Nissim, “EBITDA, EBITA, or EBIT?” Columbia Business School Research Paper No. 17-71, January 10, 2018.

21 “Berkshire and Wesco Annual Meetings,” Outstanding Investor Digest, Vol. 18, Nos. 3-4, Year End

2003, 36.

22 Seth A. Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

(New York: HarperBusiness, 1991), 71-76.

23 Michael J. Mauboussin, Dan Callahan, and Darius Majd, “Measuring the Moat: Assessing the

Magnitude and Sustainability of Value Creation,” Credit Suisse Global Financial Strategies, November 1, 2016, 6.

24 Alfred Rappaport, professor emeritus at the Kellogg School of Management, also makes this point.

He calls the steady-state value “prestrategy shareholder value” and future value creation “value created by strategy.” See Alfred Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New York: Free Press, 1986), 65-69. Also, see Martin L. Leibowitz, Franchise Value: A Modern Approach to Security Analysis (Hoboken, NJ: John Wiley & Sons, 2004).

25 Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of

Companies, Sixth Edition (Hoboken, NJ: John Wiley & Sons, 2015), 22 and Edward Bodmer, Corporate and Project Finance Modeling: Theory and Practice (Hoboken, NJ: John Wiley & Sons, 2015), 453-461. 26 Michael J. Mauboussin, Dan Callahan, and Darius Majd, “Capital Allocation: Evidence, Analytical

Methods, and Assessment Guidance,” Credit Suisse Global Financial Strategies, October 19, 2016. 27 Jonathan Haskel and Stian Westlake, Capitalism without Capital: The Rise of the Intangible Economy

(Princeton, NJ: Princeton University Press, 2018).

28 Nissim, “EBITDA, EBITA, or EBIT?” (2018).

29 Chris Mercer coined the term “EBITDA Depreciation Factor.” See Z. Christopher Mercer, “EBITDA

Single-Period Income Capitalization for Business Valuation,” Business Valuation Review, Vol. 35, No. 3, Fall 2016, 86-102.

30 ROIIC makes the strong assumption that all of this year’s incremental NOPAT is attributable to the

prior year’s investment. ROIIC can also be very noisy for companies that make lumpy investments. One solution to both of these problems is to calculate three- or five-year rolling ROIICs.

31 Stewart C. Myers and Nicholas S. Majluf, “Corporate Financing and Investment Decisions When Firms

Have Information That Investors Do Not Have,” Journal of Financial Economics, Vol. 13, No. 2, June 1984, 187-221.

32 Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of

Investment,” American Economic Review, Vol. 48, No. 3, June 1958, 261-297.

33 The companies with higher EBITDA Depreciation Factors would, on average, have higher debt-to-

total capitalization ratios. But if you assume an increase in the cost of equity and cost of debt and reweight the contributions, the net difference is not meaningful. The main point is return on invested capital and growth largely determine valuation. See Marc Goedhart, Timothy Koller, and David Wessels, “The Right Role for Multiples in Valuation,” McKinsey on Finance, No. 15, Spring 2005, 7-11 and Robert W. Holthausen and Mark Zmijewski, “Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies,” Journal of Applied Corporate Finance, Vol. 24, No. 3, Summer 2012, 26-38.

34 This passage from the book, Conspiracy of Fools, captures this point:

“We need to keep investing to grow as fast as possible. Merrill Lynch says our valuation is all about EBITDA, not earnings.”

EBITDA. A fancy Wall Street term for profits, with all of the financial expenses removed. It stood for “earnings before interest, taxes, depreciation, and amortization.” Steady growth in EBITDA could be a sign of future strong profits, but not if it was being accomplished by manufacturing full, after-tax losses. [Ken] Lay couldn’t believe what he was hearing. Was [Rebecca] Mark really arguing that the deeper into a hole she got, the better off her company would be?

“Rebecca, that doesn’t make any sense,” he said. “Surely you understand that if you put capital into projects with returns that are below the cost of that capital, ultimately you’re going to go bankrupt.” “This is what Merrill tells me is the way things are around this industry,” Mark replied. “We have to grow EBITDA. That’s all that matters.”

See Kurt Eichenwald, Conspiracy of Fools: A True Story (New York: Broadway Books, 2005), 278. 35 “Professor Aswath Damodaran on Valuation,” SumZero, July 13, 2018.

36 An, Bhojraj, and Ng (2010).

37 Daniel Rasmussen, “Private Equity: Overvalued and Overrated?” American Affairs, Vol. 2, No. 1,

Spring 2018.

38 J. Scott Armstrong, “Combining Forecasts: The End of the Beginning or the Beginning of the End?”

International Journal of Forecasting, Vol. 5, No. 4, December 1989, 585-588.

39 Pamela M. Stumpp, Tom Marshella, Mike Rowan, Rob McCreary, and Monica Coppola, “Putting

EBITDA In Perspective: Ten Critical Failings of EBITDA As The Principal Determinant of Cash Flow,”

Moody’s Investors Service Global Credit Research, June 2000.

40 Nissim, “Terminal Value” (2018).

41 Jack Curran, “Infographics: Top 10 Dying Industries in North America,” IBIS World, June 19, 2018.

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