How retail investors can profit from EV/EBITDA
Equity share valuation is all about choosing the suitable multiple, says Mr Sanjiv Agrawal, Partner and National Head - Valuation Services, Ernst & Young. "Across the financial press targeted at retail investors, one factor that strikes a corporate analyst is the focus on price earnings (PE) multiple with minimal importance given to other multiples, enterprise value/earnings before interest, tax and depreciation & amortisation (EV/EBITDA) multiple in particular," he observes.
Here is Mr Agrawal's take on a few questions from Business Line.
What is the reason for the common bias towards PE multiple?
This may be attributable to the fact that PE multiple is relatively easier to calculate based on published results of listed companies compared to the EV/EBITDA multiple. In contrast, most analysts would swear by EV/EBITDA multiple.
Why so?
In our view, the EV/EBITDA is a smarter ratio to be used as part of comparable multiples analysis. Smarter, because it is purely driven by business operations of the company unlike PE multiple, which additionally gets impacted by non-business factors of discretionary or non-recurring nature. Non-business factors are usually less predictable from retail investors' point of view.
PE is so simple to calculate: Price per share divided by the EPS (earnings per share). And you are bashing it?
Simple to calculate, yes; but it has several deficiencies, especially in the Indian context. Most Indian companies' P&L (profit and loss) accounts feature significant 'other income', which is usually not related to business operations and varies a lot fr om year to year.
Also, by definition, growth drivers and risk factors of 'other income' are quite different from income from business operations. A key item is income from investments, which is driven mainly by interest rate scenario, investments sale activity during the year, and also non-market rate related investments made by the company (in related entities).
Another item usually is non-recurring income, which by definition should not be considered for valuation analysis, as it is neither recurring, nor predictable.
Does it also matter that PE multiple is influenced by interest and depreciation expense?
Another deficiency, this is, of PE multiple. Both these items, interest and depreciation, which are charged to P&L, are not uniform across businesses. Interest expense is dependent upon credit rating of borrower and the gearing employed in the business, both of which can be different for a potential buyer of that business and so may not be very useful for market value analysis.
Depreciation charge can be quite different based upon age profile of assets and policies vis-ŕ-vis the straight line method vs the WDV (written down value) method of depreciation followed by various companies.
If we decide to switch to the alternative, that is, the EV/EBITDA multiple, how do we go about the exercise?
It should first be noted that the EV/EBITDA multiple, being a brilliant metric, is more tedious to compute than the PE multiple. EBITDA, the denominator, overcomes all the deficiencies that PE suffers from. But, one needs to make some adjustments...
Such as?
Add back to 'net profit after tax' the charge for depreciation, interest and tax, and also remove the non-operating/non-recurring items of income/expense. The removal of latter items may not be easily possible as requisite information is not very transparent in annual accounts as per Indian company law format.
Making adjustments to the price, i.e. market cap is a little more tedious in fact. One needs to reduce market value of non-operating assets (e.g. surplus properties, investments, loans to group companies) from market cap. Loan funds borrowed by the company need to be added to the market cap to arrive at EV, the enterprise value.
On how the metric can be put to use.
The EV/EBITDA multiple can be compared to probe real (business) or market imperfection related reasons for differences in EV/EBITDA multiple across various comparable companies. A similar PE multiple analysis will not be amenable to this probing.
For example?
Two companies in a sector may have similar PE multiple but very different EV/EBITDA multiple. A PE multiple analysis may suggest that both are similarly valued by the market whereas in reality EV/EBITDA multiple analysis will highlight use of very different multiples for business valuation of the two companies by the market.
EV/EBITDA multiple analysis may upon further probing suggest that market will likely in future work towards converging both companies' EV/EBITDA multiple to a similar level (assuming broad operating similarities in the companies), providing basis for buy or sell investment opportunities.
And, in the converse?
On the converse, similar EV/EBITDA multiples but very different PE multiples may not suggest converging of both companies' PE multiples. The divergence of PE multiples may be due to non-operational reasons. For instance, the company with lower PE multiple may have invested significant sums in related entities with lower than market returns. And so, the latter will not yield any significant buy/sell opportunity for an investor.
The bottom line, therefore?
EV/EBITDA ratio's increased usage would benefit capital markets also as retail investors appraise corporate managements more effectively while making smarter investment decisions for themselves. We need to help retail investors by providing this ratio to them periodically.
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While the above post makes interestin reading. It is doubtful whether it is practically useful.
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