ROI Connect member Calvin D. suggested I go over EBITDA and EBITDA multiples, which I use extensively when quickly evaluating where a stock is valued.
When you look at most investments, you’re trying to estimate what kind of annual return you might receive if you bought it. For example, purchasing a five-year bond for $100 with a 5% interest rate would earn you $5 per year (5% annual “return”). You could also say you bought the bond at a 5% interest rate “yield.” Additionally, if you inverted the metric, you could say you purchased the bond at 20x interest.
Equities (stocks) are much more complicated than bonds because they don’t guarantee cash distributions to the investor. A company makes profits that vary year-to-year, and the board of directors and management can choose to do what they want with the cash: horde it, reinvest it into the business, use it to buy other companies, distribute it to shareholders via dividends, repurchase shares, etc.
Company valuations are complicated, so the “truest” way to value them is through a discounted cash flow (DCF) model, which tallies up all the cash flows the company is expected to earn in the future and then takes into account how long we have to wait for those cash flows. Short of doing this, we try to get a feel for how cheap or expensive a stock is through metrics, just like we did with the bond example.
Enterprise Value (EV) is how much you’re buying into the company and considers the value of the cash and debt the company has. It’s almost always a better metric than Market Cap. Next, we want to ask ourselves if we buy this company for “X” Enterprise Value, how much “Y” will we get back in return per year?
If the company is growing and reinvesting, we don’t care as much about cash, but instead, we care about how fast they’re growing (Revenue Growth) and how profitable their products are (Gross Profit Margin). Thus, I like to compare the current EV to estimated Gross Profit 1, 2, 3+ years in the future. That gives me a sense of how much I have to wait to have a reasonable Gross Profit return on my purchase today.
If the company is more mature or stable, we care mostly about how much cash the company will produce in the near future. A standard metric is EV/EBITDA, which compares the whole company’s value to the cash flow the company produces. 10x EV/EBITDA would mean that we could expect the company to make $1 for every $10 of its value per year. Investors don’t get all this money, though, as some of that $1 needs to go to capital expenditures, debtors, and the taxman.
The worse the business’s quality or growth, the lower its EBITDA multiple should be (higher relative cash flow). As investors, we want to be compensated more per year if the company is at-risk, struggling, or not growing. In my experience, 4.0x EV/EBITDA indicates a weak, struggling business possibly close to bankruptcy, while a growing software company can be attractive at over 25x EBITDA depending on growth. Most normal companies I’ve looked at, though, should trade somewhere between 7-15x EBITDA.