The Uninformed Investor: “This stock is so cheap! The current stock price is only $0.50!”.
The Smart Investor: “Umm…the stock price means nothing. Your stock’s EBITDA multiple is negative!”
I know. Cheesy example. But hopefully, it gets the point across. Just because the stock price is trading under $1 doesn’t make it cheap. The stock is only “cheap” if the value you’re getting back exceeds the price.
As the Smart Investor correctly pointed out using the EV / EBITDA valuation multiple, good value investors determine cheap versus expensive based on the price they’re paying relative to earnings and cash flow.
Like cash flow and profit ratios, valuation ratios provide a consistent methodology for benchmarking and analyzing trends. Unlike cash flow and income statement-based ratios that convert raw financial statement data into metrics that reveal insights about the operations of a business; valuation ratios help investors to compare the valuations of businesses.
In this post, I discuss the 12 valuation ratios (also known as valuation multiples) that allow investors to quickly estimate a business’s value relative to its earnings, as well as how to compare valuations of comparable companies. I’ve also discussed Profit & Return Ratios, Credit Ratios, and Cash Flow Ratios previously.
I’ve also created a spreadsheet template you can use to calculate the 12 valuation ratios I discuss. The spreadsheet contains three tabs:
Cheat Sheet: This tab lists Valuation ratios and formulas used to calculate each ratio.
[Example] Calculator: You can use this tab calculate all the ratios discussed for any business by manually entering the financials required in designated cells colored in yellow under the “Required Data” section.
[Linked] Calculator: This tab has formulas that are powered by finbox.io’s Spreadsheet add-on so you can use it to automatically fetch data for supported public companies by simply changing the ticker symbol in the designated cell.
Computationally, it’s important to recognize the connection between the numerators and denominators used in calculations. Since enterprise value sums the value available to debt and equity holders, the denominators used in enterprise value ratios typically include earnings available to both types of stakeholders (like EBITDA or EBIT). Likewise, equity value multiples aren’t usually computed using income before interest expense because shareholders can’t claim earnings before paying interest on the issued debt.
You can blame it on my investment banking, but in practice, I prefer to discuss valuations based on enterprise value multiples. There are exceptions of course, such as commercial banks and investment funds wherein enterprise value multiples are difficult to calculate and therefore less meaningful.
Why the preference for enterprise value multiples you ask? Enterprise value multiples have two key advantages over equity value multiples:
Adjust for Differences in Capital Structure
Enterprise value multiples aren’t easily skewed by differences in capital structure (the mix of debt and equity). All other things being equal, firms with more debt in their capital structure will have higher P/E multiples since their returns on equity will be higher. While that’s not all bad, it can make it more difficult to compare valuations based on operating performance and earnings.
Don’t Assume That Equity Definitely Has Value
Enterprise value multiples don’t immediately assume that the equity of a business has value. This can be a dangerous assumption. For example, a firm may have $10 in EBITDA, $2 in Net Income, and $60 in debt. Similar firms in the sector may trade at EBITDA multiples around 5x and P/E multiples of 10x. If an investor relied only on the P/E multiple to estimate the value of equity, they would conclude that the equity is worth $20 ($2 Net Income * 10x P/E multiple). If they used the EBITDA multiple they would accurately conclude that the firm is insolvent and that the equity is actually worthless. Here’s the math that would lead them there:
Debt = $60
EBITDA = $10 x 5x
Selected EBITDA multiple = 5x
Enterprise Value = EBITDA x EBITDA multiple = ($10 * 5x) = $50
Equity Value = Enterprise Value – Debt = $50 – $60 = -$10
That said, equity value multiples are still useful when these two weaknesses aren’t of concern. Equity multiples are also more popular in the news media since they’re easier to compute and minority shareholders can’t influence capital structure decisions. Lastly, enterprise value multiples are not meaningful for most stocks in the financial sector since stocks in this sector have a large amount of debt in their capital structure. That’s why I’ve picked a mix of six commonly-used enterprise value multiples and six equity value multiples for this list.
For multiples that use earnings in the denominator, it’s common to compute ratios using historical and forecasted data. Historical valuation multiples are calculated based on the last twelve months (LTM) of data. Forecast or forward (Fwd) multiples are typically based on the nearest fiscal year or the fiscal year after next fiscal year.
Valuation ratios vary significantly by Sector, so it’s important to adjust expectations accordingly. To provide some guidance, I list the median valuation multiples in each Sector as of November 2017 based on finbox.io database.
EV / Revenue, also referred to as Revenue Multiple, Sales Multiple, or EV to Sales Multiple measures the dollars in Enterprise Value for each dollar of revenue. High-profit margins are highly correlated with higher revenue multiples. Revenue multiples are especially useful when a firm has negative EBITDA or EBIT, as might be the case with rapidly growing companies or successful internet startups. They also are the least susceptible to accounting differences between otherwise similar businesses.
EV / EBITDA also referred to as EBITDA Multiple is the most popular enterprise value multiple. EBITDA multiple measures the dollars in Enterprise Value for each dollar of EBITDA (See EBITDA for benefits). Firms with high growth rates typically trade at higher EBITDA Multiples.
EV / EBIT is also referred to as EBIT Multiple, and measures the dollars in Enterprise Value for each dollar of EBIT. When capital expenditures are a significant consideration for the business, EBIT multiples may be better at capturing the value of capital efficiency. Subtracting D&A does, however, make EBIT susceptible to differences in depreciation and amortization policies.
EV / Invested Capital measures the dollars in Enterprise Value for each dollar of capital invested by shareholders and lenders. The invested capital multiple is especially useful when capital assets are a key driver of revenue and earnings. Stocks trading at high multiples of invested capital may also be more susceptible to competition, since investing in similar assets will be attractive to investors.
Invested Capital = Total Equity + Total Debt
EV / Invested Capital = Enterprise Value / Invested Capital
EV / (EBITDA – CapEx) also referred to as EBITDA minus CapEx Multiple is similar to the EBIT multiple. EBITDA less CapEx is better at capturing value differences for growing companies since accounting for capital expenditures is less subjective than depreciation. When capital expenditures are cyclical or lumpy, analysts compute this ratio using the three-year average capital expenditures in the denominator.
EV / (EBITDA – CapEx) = Enterprise Value / (EBITDA – Capital Expenditures)
EV / Free Cash Flow measures the dollars in Enterprise Value for each dollar of free cash flow. The EV to Free Cash Flow multiple captures the working capital requirements of a business since cash inflows and outflows related to receivables and payables are reconciled in the cash flow statement.
Free Cash Flow = Cash Flows from Operations + Cash Flows from Investing
EV / FCF = Enterprise Value / Free Cash Flow
P/E Ratio or Price / Earnings ratio is the most popular equity value multiple; it indicates the multiple of earnings that stock investors are willing to pay for one share of the firm. The P/E Ratio is nonetheless susceptible to several pitfalls which the PE conundrum video by Khan Academy does a great job of explaining.
Price / Sales compares a firm’s equity value to the twelve months of booked sales. Like the EV to Sales, the Price to Sales multiple is primarily useful when valuing firms with negative or depressed earnings.
Price / Book or Price / Common Equity compares a firm’s market value of equity to the amount of common equity listed on the balance sheet. Price to Book ratio is commonly used to compare banks because most bank loan assets and deposit liabilities are constantly revalued to reflect their market values. This ratio is also popular with value investors, as it provides a rough indication of downside risk if the firm was to become bankrupt.
Price / Tangible Book Value or Price / Tangible Common Equity compares a firm’s market value of equity to its book value of tangible common equity value. Tangible common equity subtracts goodwill and intangibles from the listed total common equity since these assets often have little resale value in a bankruptcy. Tangible Equity gained popularity during the 2008–2009 economic crisis since it held banks and financial institutions to a stricter standard of balance sheet health from the perspective of common shareholders.
Tangible Common Equity = Common Equity – Goodwill & Intangibles
Price / Book = Market Cap / Tangible Common Equity
Price / Cash Flow compares a firm’s equity value to the Cash from Operations (OCF) reported on its Statement of Cash Flows. Investors often prefer to use Cash Flow vs. Net Income as the denominator, since it’s more difficult for management to skew OCF with clever accounting practices.
Price / Cash Flow = Market Cap / Cash Flows from Operations
The Price-Earnings to Growth abbreviated as PEG Ratio is a crude heuristic used to measure the level of earnings growth reflected in a stock’s market price. The benchmark for the PEG ratio is 1, and stocks with a PEG under 1 are considered undervalued. Similarly, those with a PEG greater than 1 are considered overvalued. Note, though this ratio is very popular, it provides a rough approximation of intrinsic value at best.
PEG Ratio = (Price / EPS) / (% Growth Rate * 100)
Median by Sector
PEG Ratio Fwd
I’ve created a simple cheat sheet listing the formulas and short descriptions that you can download and print for quick reference.