- Surgical Investing
- Posts
- The Acquirer's Multiple
Thanks for reading The Dividend Growth Newsletter!
Today I'll be sharing how I find the intrinsic value of a company using the EV/EBIT ratio.
If you want to join 1,750 other investors learning about dividend investing tactics and analysis, subscribe below:
If you like what you’re reading, please share the newsletter with your friends!
Also, check out my other articles here and find me on Twitter @DrDividend47!
Lastly, this week I made my first video covering how to use EV/EBIT to value Home Depot! You’ll find it later in the article or you can jump straight to it here.
Today’s issue is brought to you by Wander!
Invest in these vacation rentals in a few clicks ☝
With Wander.com, you can unlock access to vacation rental investing without the hassle and headache of doing it yourself.
Wander REIT is the first and only institutional-grade vacation rental investment product. That means investors get all the tax-advantaged benefits of a REIT in a new asset category: vacation home rentals. Instead of the traditional apartment or office-building REITs, Wander REIT invests in the best of the best of vacation rentals.
Enjoy targeted 8% dividends and a 14% targeted total return with appreciation from hand-picked, stunning vacation homes – starting with a $2,500 minimum – without having to buy a property, change light bulbs or deal with guests. And for a limited time, new REIT investors may get an opportunity to invest in Wander’s next round of funding.
Now for today’s piece:
The Acquirer's Multiple: Using EV/EBIT to find a stock's intrinsic value
Highlights
If you only have a few minutes to spare, here are some takeaways about finding a company’s intrinsic value:
• Intrinsic value is based on a company's underlying characteristics, such as its cash flow, earnings, and other relevant metrics.
• Valuation multiples, such as P/E, P/S, P/B, EV/EBITDA, and EV/EBIT, can be used to value a firm.
• EV/EBIT is the most accurate valuation multiple in my opinion because it takes into account a firm's debt and cash.
• P/E does not take into account a firm using debt to grow its earnings.
• EBITDA excludes depreciation and amortization when valuing the business, which can lead to inaccurate results.
What Is Intrinsic Value?
Intrinsic value is what an asset is worth.
It’s based on a company’s underlying characteristics, such as its cash flow, earnings, and other relevant metrics. It is not based on market sentiment or short-term fluctuations in share price.
Instead, a company’s intrinsic value is based on a longer-term assessment of the investment's ability to generate value over time.
Investors who focus on intrinsic value are less likely to be swayed by short-term market fluctuations and instead can make more informed decisions about whether a stock is truly worth its current price.
In addition, focusing on intrinsic value can also help investors avoid overpaying for investments that may be overhyped or overvalued, and instead identify opportunities where the market has undervalued a particular investment.
This can lead to more profitable investment decisions and protect against bigger downsides.
Value investors will search for the intrinsic value of a firm and aim to buy below that number, creating a margin of safety.
Using Valuation Multiples
Valuation multiples are multiples used to value a firm when compared to competitors. The most common valuation multiples are:
Price to Earnings Ratio (P/E)
Price to Sales Ratio (P/S)
Price to Book Value (P/B)
Enterprise Value to Earnings Before Interest, Taxes, Debt, and Amortization (EV/EBITDA)
Enterprise Value to Earnings Before Interest and Taxes (EV/EBIT)
P/E is the most commonly used valuation multiple but I find a few flaws in it.
P/E doesn’t take into account a firm using debt to grow its earnings.
Companies can play accounting games with depreciation and amortization to make earnings look better than they truly are.
Valuing a firm based on the price of its stock involves its market capitalization which doesn’t take into account the cash and debt of a firm.
Instead, I use EV/EBIT for valuation.
What Is EV?
From Tobias Carlisle’s Book: “The Acquirer’s Multiple”
EV stands for Enterprise Value and is found by taking the market cap of a firm, adding debt, and subtracting cash.
Why use Enterprise Value?
When buying shares of a company, I find it helpful to use the Warren Buffett approach and act as if you were buying the whole company.
If you were buying the whole company, you would be responsible for its debt, and you would have the ability to use the cash for whatever you’d like.
So where most valuation methods focus on price, I choose to focus on enterprise value.
The price fluctuates due to investor sentiment, fear, and greed. The enterprise value paints a truer picture of the business by factoring in debt and cash.
What Is EBIT?
EBIT stands for Earnings Before Interest and Taxes.
This is the income derived from a business’s core operations and is the income available to all debt and equity holders.
I choose to compare companies by their EBITs instead of Net Profit because I want to exclude interest expenses and taxes. A company’s interest expenses are external to the business and so are its taxes.
Let’s say we were to compare two companies, one in the UK and one in the US. The profitability of these companies will be affected by the interest rates and taxes of their home country.
Profitability is not giving us a clear winner in this case because the businesses are being penalized for being in different locations.
EBIT removes the negative effects of comparing companies from different countries and aims to give investors a level playing field to fairly assess companies across countries and industries.
Why Not Use EBITDA?
You may have heard of EBITDA which is more often used than EBIT, but I don’t like to use it.
EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization.
It's very similar to EBIT, but EBITDA excludes depreciation and amortization when valuing the business.
If you don’t already know, depreciation is a value deducted from a tangible asset (like a bulldozer) and amortization is a value deducted from an intangible asset (like a patent).
I don’t like valuing a business and excluding the money spent on depreciation and amortization because those are expenses the business incurred. The business spent money on bulldozers or patents and that’s money that could be sent to shareholders.
The most efficient companies require less and less capital to grow and can produce more earnings relative to the amount of assets they own.
EBITDA excludes a large amount of capital spent on expenses (CapEx) and makes very capital intense companies look cheaper and more efficient than they are.
EBIT takes into account the depreciation and amortization of a business which I think is necessary when looking at a business’s efficiency.
For these reasons, I find EV/EBIT the most accurate valuation multiple.
How Do You Use EV/EBIT?
When I use EV/EBIT, I’ll look at a firm’s competitors and see what their EV/EBITs are. I’ll take the average of the competitor’s EV/EBITs and apply that multiple to the EBIT of the firm I’m interested in. Then I divide by the number of shares outstanding to find an intrinsic value.
For example, let’s say I’m interested in Firm A. It has an EBIT of $100 and 10 shares outstanding. Firms B and C are competitors and they trade 20x and 10x EV/EBIT respectively. The average EV/EBIT of Firm B and Firm C is 15x.
I take that 15x average and multiply it by Firm A’s EBIT of $100. I then get an answer of $1,500. The last step is to divide that $1,500 by the number of shares outstanding, 10. In the end, I find an intrinsic value of $150 per share for Firm A.
Real-World Example: Finding The Intrinsic Value Of Home Depot Using EV/EBIT
To fully explain how I value a company using EV/EBIT, I created a video showing my valuation process for the company Home Depot.
Check it out below and send some love/feedback my way!
In the event a company has no true competitors (ASML, Essilor-Luxottica) or if the company always trades a premium to competitors (Costco, Eli Lilly) I’ll use the 5-year median EV/EBIT of the company and apply it to its EBIT.
I’ll then follow the same steps as above to find the intrinsic value and aim to buy below that number.
Final Thoughts
When I first started investing, I didn’t pay too much attention to valuation.
This led to me paying a little too much for some stocks.
One famous example of why valuation matters is the Dot Com Bubble of the early 2000s. During that time, the highest-valued company in the world was Cisco Systems, trading at 196.2x P/E with a market cap of $555.4 billion.
If an investor bought the top at $146.75 per share in 2000, they still haven’t recouped their investment 23 years later.
Valuation matters.
After learning about valuation, I was able to recognize a lot of my holdings were overvalued. I decided to trim some shares from a few holdings and I also learned how to find a good price point to add more shares.
Now I can enter positions confidently with a margin of safety and not overpay.
Have fun finding the intrinsic value of your investments!
Until next time,
Dr. “Intrinsic Value” Dividend
Links And Memes
Here are some of the best things I saw this week:
The incredible story of how Red Bull used social proof to become the biggest energy drink in the world – I’ll argue that Red Bull has the best marketing of any company (Daniel Murray)
An AI-generated thread of Star Wars characters as teapots – I’ve got dibs on Jabba the Hut teapot (Ian Miles Cheong)
And of course, some memes:
Like what you’re reading?
Subscribe to get free investing content sent straight to your inbox every Monday.
Don’t forget to check out my website full of awesome free resources to jumpstart your investing!
Interested in advertising with Dr. Dividend and The Dividend Growth Newsletter?
You can fill out this form to get your product at the top of the newsletter and into the hands of over 1,750 dividend investors!
Reply