UnitedHealth Group Inc (NYSE: UNH) trades at an EBITDA multiple of 11.5x, which is lower than the Healthcare sector median of 16.1x. While this makes UNH appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the EV/EBITDA ratio. In this article, I will break down what an EBITDA multiple is, how to interpret it and what to watch out for.
Understanding Valuation Multiples and the EV/EBITDA Ratio
A Multiples Valuation, also known as a Comparable Companies Analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (Peer Group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
An EBITDA Multiple, also known as Enterprise Value-to-EBITDA Multiple (EV/EBITDA), measures the dollars in Enterprise Value for each dollar of EBITDA. To determine if a company is expensive, it’s far more useful to compare EV/EBITDA multiples than the absolute stock price. Furthermore, its key benefit over the P/E multiple is that it’s capital structure-neutral, and, therefore, better at comparing companies with different levels of debt. The general formula behind an EBITDA Multiples valuation model is the following:
Enterprise Value = EBITDA x Selected Multiple
An EBITDA multiple is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar EV/EBITDA ratios, we can come to some conclusions about the stock if the ratios are different. I compare UnitedHealth’s EBITDA multiple to those of Anthem, Inc. (NYSE: ANTM), WellCare Health Plans, Inc. (NYSE: WCG), Humana Inc. (NYSE: HUM) and Aetna Inc. (NYSE: AET) in the chart below.
Since UnitedHealth’s EV/EBITDA of 11.5x is higher than the median of its peers (7.1x), it means that investors are paying more than they should for each dollar of UNH’s EBITDA. As such, our analysis shows that UNH represents an overvalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of $154.58 per share which implies -29.1% downside.
Note that the selected multiple of 8.0x in the analysis above was determined by averaging UnitedHealth’s current EBITDA multiple with its peer group.
EBITDA Multiple’s Limitations
Before jumping to the conclusion that UnitedHealth should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to UnitedHealth, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in EBITDA multiples could be due to a variety of factors. For example, if you accidentally compare UnitedHealth with lower growth companies, then its EBITDA multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: EBITDA multiples model
Now if the second assumption does not hold true, UnitedHealth’s higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to UNH. However, keep in mind the limitations of an EBITDA multiples valuation when making an investment decision. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you continue to research UnitedHealth to gain a better understanding of why it’s trading at a premium.
Author: Brian Dentino
Expertise: financial technology, analyzing market trends
Brian is a founder at finbox.io, where he’s focused on building tools that make it faster and easier for investors to research stock fundamentals. Brian’s background is in physics & computer science and previously worked as a software engineer at GE Healthcare. He enjoys applying his expertise in technology to help find market trends that impact investors.
Brian can be reached at email@example.com.
As of this writing, Brian did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.
Read more awesome articles like this one on VintageValueInvesting.com!