Enterprise value (ev) is the market value of the debt and equity less cash held by the company. Earnings before interest, taxes, depreciation, and amortization (ebitda) is a proxy for how much cash flow does the business generates. By dividing the enterprise value by ebitda numbers, you discover how long will it take for the company to pay back the initial investment.
The shorter the period the better it is. For example, a business that generates $33,000 a year is more attractive than a business that makes $14,000, assuming both will last and cost the same.
The ev to ebitda ratio represents this idea. "What a ratio of eight times ev to ebitda," writes Michael Shearn in The Investment Checklist, "is that the investment will pay itself in eight years."
In this essay, I describe the ratio's main weaknesses and how you can better prepare for them. I end the article with a few examples of companies trading at low ev to ebitda ratios.
There is a reason why Charlie Munger called ebitda earnings "bullshit earnings." In his mind, ebitda misses out on two key points: the amount of leverage and the amount of capital expenditures required to maintain the business.
Another flaw of the ratio is that it looks at a single point in time. But what matters to investors are trends over time. That is, whether earnings will grow in the future is more important than current earnings or last year's earnings.
For example, in June of this year, I bought the stock of Signet Jewelries (SIG on Nyse) One of the reasons I purchased SIG was because for the prior seven years, the average was $800 million. But because the 2018 was loss $579 million, the stock had more than halved. to cannot pick up such a discrepancy.
Like most things in life, the problem does not lie in the ev to ebitda ratio but how the user intends to use it. I typically use ev to ebitda ratio to quickly screen for cheap stocks. Other investors use the inverse logic; they use the ratio to estimate how valuable a company is. They assume that the higher the ratio, the more valuable the company.
Yet, even with the flaws mentioned, ev to ebitda ratio is widely used, and ebitda figures are widely accepted. Read any loan covenants of a publicly-traded firm and you will see that lender covenants that address ebitda figures. That is, if ebitda for a quarter falls below a specific number, a higher interest rate will be charged.
And so, to use Silicon Valley nomenclature, this ratio exhibits a "network effect." One of its strengths is that it is widely used by both companies and by Wall Street analysts.
Take, Luca Franza of Ausonio Fund as example.In the now famed investment thesis for Rain Industries, he writes:
"Rain trades at a P/E of 2.7x and EV/EBITDA multiple of 5.1x. Using cyclically adjusted earnings and EBITDA, which we will assume to be the average over the last five years, Rain trades at a P/E of 1.7x and EV/EBITDA of 4.2x."
Another use of the ev to ebitda ratio is that it allows us to observe a company's valuation over time. Canterbury Consulting shows, in a quarterly asset class report, that for the Russell 2000, a popular index, / was 16 times, while the 10-year average ratio was 14 times, and. For the S&P500, Canterbury researchers show that the current TDA was 1mes, while the 10-year average was ten times. You can download the Canturbury report.
When bored, I enjoy finding out the ev to ebitda ratio of portfolio companies owned by asset managers I admire. For example, a few weeks ago, I reviewed Third Street Avenue Capital Management. I saw that for the 31 companies Third Street owned as of the second quarter of this year, most portfolio companies ev to ebitda was in the double digits. Only Carter Bank Trust Advansix Inc. traded at a ratio of six times; MYR Group at a ratio of seven times. The other single-digit companies, at nine times the ev to ebitda, were Seaboard Corporation, Comfort Systems and TRI Pointe Group and Kaiser Aluminum Corporation.
Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.
GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. For example, see how easy it is to review Signet Jewelers 10-year financials.
I often screen for stocks trading at low ev/ebitda. While it is insufficient to make an investment decision based on the ratio, it does serve as a starting point or as a filter mechanism. I conclude this essay with three companies in my portfolio that are trading below three times the ev to ebitda ratio.
First, the sport-equipment manufacturer Nautilus' enterprise value is $54 million, and ebitda is $31 million. Second, Flexsteel Industries, the sofa manufacture, enterprise value is $102 million, and 2018 ebitda is $33 million. Third, Gulfport Energy, a producer of natural gas, enterprise value is $2,670 million, and 2018 ebitda is $1,046 million.
The gas and oil industry is not for the faint of heart. The S&P Oil and Gas Equipment services halved this year and is down 80% compared to five years ago. And from the macro to the micro: Noble Corporation (NE on Nyse), whose price is now less than two dollars a share, traded for $28 per share in five years ago. Gulfport Energy (GPOR on Nasdaq), which I bought a few months ago, now trades at $3 compared to $60 five years ago. At least the two firms are still in business. Atwood Oceanics, Inc., Hercules Offshore, Inc. and Paragon Offshore PLC - all filed for bankruptcy protection.
It is a cyclical business per se. In The Investment Checklist , Michael Shearn writes that "certain industries operate independently of the economic cycle. In such case, the product or service may be more of a necessity." He lists tobacco companies, pipelines carrying oil and gas and student housing REITs as examples. And as the U.S. economy continues to expand (the longest expansion recorded), the oil and gas industry contracts. What goes down must go up?
To answer, we should first look at the demand variables. I refer the reader to page 12 of the NE's 10-K report for example, where management discusses 25 factors that affect the price of oil and gas and the level of activity in offshore exploration.
To name just a few of the factors: the level of production in non-OPEC countries, merger and divestiture activity among oil and gas products, the political environment of oil-producing regions (including uncertainty or instability resulting from civil disorder) and the discovery rate of new oil and gas reserves either onshore or offshore.
In short, to foresee where the oil and gas industries are heading is to prognosticate.
So instead let us name a few of the current reasons why the industry and its shareholders are depressed. First is the price of oil. Five years ago a barrel of WTI Crude Oil cost over $90. It is now about $55. And not unlike the gold rush, if commodity price is down, no one tries to dig it out of the ground.
The second reason is that daily crude oil production increased to four million from one and half million barrels. So, the demand of service from offshore fields, which are more expensive, declined.
The third reason is the demand and supply equation. There are simply too many rig suppliers and too little demand for them.
Yet I think the imbalance is temporary. Visit the Macrotrend website to see that over the past decade, the price of oil moved - and at times, frantically up and down - but upwards was the overall trend. Or instead of staring at the computer screen, you can just ask anyone older than sixty-five if gas prices were cheaper or more expensive when they were thirty.
So I speculate that the price of oil will rise again and that the price of gas and oil companies will eventually follow. I made this bet by buying a few shares in Noble Energy.
While Noble is now fraught with many risks (to name a few: the company is being sued; it is burning cash flow and the leverage ratio and interest expense ratio are higher than ever before), I focused most of the reading about the company before the gas and oil industry turned sour.
And when times were good, Noble operated with a shareholder-oriented management as it never made acquisitions using equity but instead used debt and internal cash flow; It ran a conservative balance sheet with a leverage ratio of less than 40%.
More numbers: Five years ago Noble was valued over one times the company's 2014 revenue. It now trades at less than half the 2018 revenue. It is also trading at historically significant discount to book value. At the end of 2014 the book value per share was $26, and during that year the stock traded hands as high as $33 and as low as $14. The minimum price to book value was 54%. Contrast that with today's pricing. Today, the company reports a book value of $18 per share and a two-dollar price tag is 89% discount to book value.
Before I bought the stock of Gulport and Noble, I knew little about the gas and oil industry. The following two books tremendously helped: Written by Jens Zimmermann, The Oil and Gas Industry Guide: Key Insights for Investment Professionals contains key valuation methods and industry knowledge. It is a somewhat technical book.
For broader understanding of the business, Bryan Burrough’s The Big Rich: The Rise and Fall of the Greatest Texas Oil Fortunes is a colorful portrayal of the industry's eccentric characters.
You can teach math to a horse but the horse will never be a mathematician. Similarly accountants teach us, readers of financial statements, that treasury stock is equity. But I argue that treasury stock is an asset.
Generally Accepted Accounting Principles (GAAP) says that "assets are probable future economic benefits obtained or controlled by a specific company as result of past transactions or events."
An asset has three characteristics: (1) it is likely to contribute directly or indirectly to future net cash flows, (2) the company can obtain and control others' access to it and (3) the transaction has already occurred.
When a company buys its own stock management is signaling to investors that the stock is undervalued. Also, when a company buys back its shares, each investor's ownership interest increases. So stock buybacks are valuable and meet the three characteristics of an asset.
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Yet the accounting is goofy. Consider International Business Machines (IBM on Nyse). Over the past decade, IBM's balance sheet showed deficits in the equity balance. In 2018 the loss in equity balance was $25 per share. And yet during this 10-year period, IBM was profitable (the 10-year average earnings per share is over $5). That a negative equity balance can produce profits is an accounting distortion.
The accounting distortion is the result of IBM's share repurchase program. In 2009 IBM had 1.3 billion outstanding common shares while management reported on 892 million outstanding shares as of the latest public filing, a compound annual decline of about 4% per year.
Another example is Signet Jewelers (SIG on Nyse) which I bought a few weeks ago. In 2019 SIG's management deducted from the equity balance $1,027 million because it bought 18.1 million shares. But just as the company bought the stock, management can sell the stock to the public. In SIG's case, using today's stock market, I estimated that management can easily sell the common stock at $15 per share (a 25% discount to current price) for total proceeds of $271 million or $5 per share.
Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.
GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. See how easy it is to track AT&T treasury stock purchases for example.
I asked a friend of mine who is an accountant why treasury stock is part of the equity balance and not reported as part of the assets. She explained that if treasury stock would have been reported as an asset, the accounting would get goofier. For one, she explained, a potential buyer of a company would not consider treasury stock valuable. The buyer would remove treasury stock to arrive at a fair value. So from the buyer's perspective the classification change would not be helpful.
Another reason why reporting treasury stock as an asset does not work in practice is related to the price of the stock. If company ABC’s management buys the stock at $10, and a year after the price of the stock drops to $5, under GAAP rules, company ABC would report an impairment loss, directly affecting the income statement.
This would be a double-edged sword. Just as the company operations would deteriorate (the probable reason why the stock fell in price) the company would take a further loss to the income statement.
Students of financial history will remember that prior to 1982, stock repurchases were illegal. Buyback activity, which is expected to be greater than $800 billion in 2019, was considered a stock market manipulation according to Forbes.
This activity continues to be unfavored by some. For example Senators Chuck Schumer and Bernie Sanders proposed to limit corporate stock buybacks in a New York Times Op-Ed. Their main arguments were that stock buybacks hurt the economy because indirectly they discourage investment and innovation.
Like many things in life, an action, in itself, is neither good nor bad. It just depends. It is bad action when management buys back the stock when the shares are overvalued (say, trading at above 30 times the trailing earnings per share).
It is good action when the inverse happens - when management buys back the stock at undervalued prices or if buying back the stock is the best available option.
Binary thinking just does not work in investing. Treasury stock is, at times, an asset; sometimes it’s part of the equity balance; and sometimes it's both. This similar to the Jewish tale:
Two neighbors were fighting over a financial dispute. They couldn’t reach an agreement, so they took their case to the local rabbi. The rabbi heard the first litigant’s case, nodded his head and said, “You’re right.”
The second litigant then stated his case. The rabbi heard him out, nodded again and said, “You’re also right.”
The rabbi’s attendant, who had been standing by this whole time, was justifiably confused. “But, Rebbe,” he asked, “how can they both be right?”
The rav thought about this for a moment before responding, “You’re right, too!”
"Facts are stubborn things," said my favorite American founder, John Adams. "And whatever may be our wishes, our inclinations or the dictates of our passions, they cannot alter the state of facts and evidence." And so, I collected a few facts about Frontier Communication for this week's meditation.
A few facts on Frontier are needed because Frontier’s stock is trading at 71% compared to a year ago. And as most analysts are rushing investors to cut their losses and sell Frontier position, I plan to do the opposite.
After adjusting for non-cash expenses, I expect Frontier to report on a billion dollars of after-tax cash flow. The company’s average quarterly revenue was $2.1 billion in 2018, the average quarterly expense for interest was $400 million and the average capital expenditures were $320 million.
If we remove non-cash charges, such as depreciation ($480 million each quarter) and goodwill expense ($400 million in the third quarter), we get a quarterly after-tax cash flow of $250 million. Multiplied by four quarters, we get the billion-dollar estimate. It is a fact that these after-tax earnings, adjusted for non-cash items, are higher than the after-tax earnings when the stock was trading in the double digits.
Another way to look at my estimate of Frontier's 2018 after-tax cash flow of a billion dollars is to say that the company profit margin is about 12% and that while the debt service coverage ratio is thin, it is adequate. The operating income to debt service ratio is slightly above two times. It is a fact that operating income for 2018 will be higher than $3.9 billion and that the interest expense will be $1.5 billion.
As of the third quarter of 2018 public filing, Frontier reported total assets of $24 billion. If we remove goodwill of $6.6 billion, we find tangible assets of $17.4 billion. And so, with a rate of return of capital of 5.75%, I cannot understand why there is an increased demand in investors who are shorting the company.
Twelve months ago, the short interest, as reported by Nasdaq, was $2.9 million with average daily volume of $2.7 million. As of today, the short interest is $49.4 million. The stock price declined from $8 to $2, too.
While operating results slightly improved, Frontier's valuation is materially below what the stock was valued in the past. Between 2013 and 2017, revenue grew by 14% compounded annually. In 2013, revenue was $4.7 billion, and in 2017 revenue was $9.1 billion. Earnings before taxes (EBT) grew by 6% compounded annually. The 2013 EBT was $1.5 billion, and the 2017 EBT was $2.02 billion. It is true that the after-tax cash flow declined from $857 million in 2013 to $618 million in 2017, but to me, a drop of 30% in after-tax cash flow does not explain the gloomy outlook.
If we expand our time horizon and look at the past decade we see that the stock traded as high as $194 (in 2008) and as low as $2 (current valuation). The earning multiple ranged from 6 to 12 the earnings. My estimate of a billion in after tax cash flow, alongside the reported outstanding shares of $103 million, translates a market valuation of less than one times the earnings multiple.
But the stock market’s focus is in future trends (for example, that employess are unhappy) and not in the historical record. "Quarterly revenues continue to decline at Frontier Communication," writes Wayne Nef of Value Line, an investing newsletter. "Both the consumer segment and the commercial business are under pressure. Management is optimistic that the revenue trend will turn in the fourth quarter due to new marketing programs and seasonality, but we are less sanguine."
In Seeking Alpha, the crowd-sourced financial website, you will read of a bearish outlook, too. Here are a few headlines I found: "Frontier Communications: Fundamentals Are Meaningless in a Bear Market" writes one author. "After A 60% Decline, Frontier Communications Offers Little Value," argues another. And picked by Seeking Alpha's editor as a favorite article is "Frontier Communications is uinvestable."
Ashraf Essa, who writes for The Motley Fool, is bearish, too. He warns us that "Frontier's business is on the decline, and the company had about $1 billion worth of long-term debt coming due within the next year." And that Frontier Communications shaky business fundamentals, coupled with its massive debt load, make it an extremely risk stock to own."
Since I began to buy the common stock of Frontier in March of last year, I did not pay much attention to the company. In 2017 the stock price was in the two digits and it would surely climb again, I thought to myself. I did not plan to think about Frontier before it published its 2018 fiscal year-end results, which was reported on February 28, 2019 and which I have yet to read.
But Jeff, a Charles Schwab representative, called this morning and asked whether I would be interested in lending the securities I owned. There is an increasing short demand, he said. He offered an interest rate of 10%, which is the equivalent of two Starbucks per today.
The math behind the two-Starbucks-per-day: Charles Schwab is borrowing from me 8,000 stocks at a rate of 10%. The stock is today worth $18,000 (I bought the stock for little over $40,000). This translates to an annual payment of $1,800, or daily payment of $5. The terms of the agreement between us are that Schwab may pay off the loan at any time and payments are made every month.
In 1774, Adams renounced tea drinking as unpatriotic and switched to coffee drinking according to a letter he wrote to his wife, Amelia. He would have been supportive with my securities lending practice, I am quite sure.
"The principle on which this country was founded and by which it has always governed is that Americanism is a matter of the mind and heart; Americanism is not, and never was, a matter of race and ancestry," said former President Franklin D. Roosevelt. "A good American is one who is loyal to this country and to our creed of liberty and democracy."
The spirit behind exchange-traded funds (ETFs) investing is similar. What is required of the ETF investor is (1) to form an opinion and (2) to understand the investment. And if we agree on conditions (1) and (2) then it logically follows that the ETF investor can participate in many forms of investments, from foreign-domiciled stocks to small, U.S. capitalization stocks; from investing in ETFs that track the performance of widely known indices - such as the S&P 500 and Dow Jones - to ETFs that follow the performance of energy or commodity prices.
If you believe that the U.S. population is ageing, the Vanguard Health Care ETF (VHT) is a simple strategy to follow. The ETF includes stocks of companies involved in providing medical and health care products, services and equipment. It includes 359 stocks with a median market capitalization of $81 billion. By buying shares in the Vanguard Health Care ETF you will be tracking the performance of companies such as Johnson and Johnson, Pfizer, Inc. and UnitedHealth Group Inc.
Are you determined that the world will consume more energy with time? Then you can buy Vanguard Energy ETF (VDE). For a minuscule expense of 10 basis points, the Energy ETF tracks the performance of companies involved in the exploration and production of energy products such as oil, natural gas and coal. The ETF includes 141 stocks with a median market capitalization of $50 billion. Some examples of energy companies include Exxon Mobil Corp., Chevron Corp. and Phillips 66.
Agnostic about macro-global trends but convinced that corporations are becoming more efficient and that people will be consuming more? Vanguard Consumer Discretionary ETF (VCR) tracks the performance of stocks of companies that manufacture products and provide services that consumers purchase on a discretionary basis. In this ETF you will find Amazon, Inc., Home Depot Inc., Nike Inc., Starbucks Corp. and even the controversial Tesla Inc.
You can buy any segment of the economy. There are ETFs that track financial companies such as JP Morgan and Bank of America, or utility companies such as Duke energy and Dominon energy, or consumer staples companies such as Proctor and Gamble and Coca Cola, industrial companies such as Boeing, 3M and Caterpillar, or technology companies such as Apple and Microsoft, telecom companies such as Verizon, ATT and Comcast, or material companies such as PowDuPont, Lind PLC and Ecologic and the real estate sector such as American Tower Corp., Simon Properties and Prologis.
Adequate rate of return usually follows a sound investment. If you had invested in any of the sectors, you would have done reasonably well. The financial sector 10-year rate of return was 15%; both the healthcare and the real estate sector was return was 15%; the technology sector rate was 20%. The worse performing sector over the past ten year was the energy sector, with a rate of return of 5%.
But any good idea can be turned into a bad one (see the Netflix documentary about Fyre Festival for a recent illustration). And just as exchange trade vehicles serve the value, prudent investor, they may develop into a co-dependent relationship with the speculator. Last week I came across a few ETFs that the value investor should avoid.
The Global X Millennials Thematic ETF (MILN) is one example. This ETF aims to benefit from the spending power and preferences of the U.S. millennial generation (defined by those born in years ranging from 1980-2000.) The ETF invests in companies that millennials use, such as Snap Inc., Twitter Match and Zynga.
But the value investor acts upon principles, not trends. Nothing is mentioned in the ETF’s prospectus about fundamental value-oriented valuation concepts such as price to earnings, leverage, seasoned management or return on invested capital.
The Obesity ETF is another example of a good idea turned bad. This ETF that opened in June 2016 tracks the performance of the Solactive Obesity Index link and "provides investors with the opportunity to invest in companies that may benefit from the transformational forces changing our future."
Simply put, the ETF tracks the stock of companies that claim to fight obesity. This list of companies includes Arena Pharmaceuticals (a company that develops a molecule drug), NxStage Medical Inc. (a company that develops systems for the treatment of end-stage rental disease), MannKind Corp (a company that aims to fight diabetes) and CyroLife (a distributor of cryogenically preserved human tissues for cardiac and vascular transplant applications).
The third example is Ark Innovation ETF (ARKK). The ETF’s prospectus uses buzz words such as "disruptive innovation" and "next generation Internet." This passively managed ETF (with actively-traded fees of 0.75%) has about a billion dollars in assets under management. This ETF owns Grayscale Bitcoin Trust, Editas Medicine and Organovo Holdings.
ETF investing began almost thirty years ago with the goal of reducing active management fees. When I heard John Bogle speak at conference last year, I learned that he was surprised by the immense success of passive investing. He was also worried, mentioning that ETFs serve nowadays as a means to speculate, which is the exact opposite of his original intention.
This week's meditation on ETFs was inspired by one of the last interviews Bogle, of blessed memory, gave. This Bogle interview is a reminder for us all that products are not necessarily good or bad. It is how we use them.