When it comes to financial ratios, I am sure you know the P/E, or Price to Earnings ratio, but have you used or thought of enterprise value when screening stocks?
Different types of valuation ratios
When you see a company’s P/E ratio you may know it shows a company’s valuation comparing its market value to its after tax profits.
You also know what earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA) from seeing them a few times I am sure.
But do you know these numbers can be also be used to value and compare companies you are thinking of buying?
When using these ratios, it is important to understand how each shows a different part of a company’s income statement and that affects their usefulness.
Some valuation ratios work better than others and understanding these basics can help you choose the best companies that meet your investment strategy.
Click the following link to see the results of all the best ratios we have tested: Best investment strategies we have tested.
Start with the familiar P/E
Let’s start with one of the most common valuation ratios.
The Price to earnings or P/E ratio is calculated as follows:
P/E ratio = price per share / earnings per share (EPS)
You can calculate EPS as follows:
EPS = Net Income after Tax / total shares outstanding
Instead of using per share values you can also calculate the P/E ratio like this:
P/E = Market Capitalization / Net Income
Market capitalization = share price x number of outstanding shares
You can see that the price to earnings ratio (P/E ratio) measures the level of a company’s stock price relative to its after tax profit per share, and you can use it to get an idea of a company’s valuation.
For example, a company is trading at 15 times after tax profits has a P/E ratio of 15.
What about EBIT and EBITDA
Earnings Before Interest and Taxes (EBIT) describe a company's profitability as sales minus operating expenses (OPEX). It is also known as operating income and you calculate it as follows:
EBIT = Sales – Cost of Sales - Operating Expenses (calculating from the top of the income statement)
or
EBIT = Net Income + Interest + Taxes (calculating from the bottom of the income statement)
Earnings before interest, taxes, depreciation, and amortization (EBITDA), on the other hand, show you operating profit without depreciation and amortization (both non-cash expenses).
You can use it to get an idea of the cash profits a company makes.
This makes it helpful to compare to the debt levels of highly leveraged companies or very capital intensive companies with high levels of depreciation.
Because of high depreciation and interest these companies often report losses, and you can use EBITDA to show the earnings available to pay debt.
This is how EBITDA is calculated:
EBITDA = Operating Profit + Depreciation Expense + Amortization Expense
or
EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization
Both EBIT and EBITDA show profits available to equity and debt holders, because they show income before deducting interest payments on debt. Neither complies with generally accepted accounting principles (GAAP).
Enterprise Value
The Enterprise Value (EV) gives you a better idea of the total market value of a company as it takes the capital structure of a company into consideration.
Capital structure simply means how the company is financed for example equity debt, minority interest, preferred shares and cash.
Enterprise value is calculated like this:
EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments
You can think of it as the total price you have to pay if you want to buy a company.
If you buy a company you can pay out the cash, redeem preferred stock, pay back bank loans, buy back bonds, so, EV more closely represents the company’s value.
In terms of valuing companies, EV is higher for companies with a lot of debt and little cash and a lower for companies with little debt and plenty of cash.
Ratios Using Enterprise Value (EV)
As EV gives you a more complete idea of the value of a company it is a good value to use in the valuation of a company.
For example it can be used to calculate EBIT/EV which we call Earnings Yield.
As you can see it uses EBIT and thus gives you a clean, realistic estimate of operating income and compares it to enterprise value.
Earnings Yield = Operating Income or earnings before interest and taxes (EBIT) / Enterprise Value
The same way you can calculate EBITDA Yield:
EBITDA Yield = EBITDA / Enterprise Value
When to Use a Yield or a Times Ratio
I am sure you have also seen ratios shown as a yield (with a percentage sign like EBIT / EV = 12%) or shown as times (for example PE = 5 times (the stock price is equal to 5 times earnings).
A yield ratio refers to income return on an investment.
For example, earnings yield, described above, refers to the EBIT/EV. Likewise, the interest rate or dividend yield you received from holding a particular security is a yield.
Yield ratios are useful because you can easily use them to compare the returns of different companies. And allows you to easily compare the rate with the return on other assets, for example bond yields, interest rates or a real estate capitalisation rate.
If you look at multiple or times ratios like P/E it is not a yield but it tells you that you have to for example pay seven years’ worth of earnings for a company with a P/E ratio of 7.
This is also easy to understand but more difficult to compare to other investments prices in percentages like interest rates and bond yields.
Summary and conclusion
As you have seen there are a number of ways you can value a company using different profit numbers and valuation calculations.
What is however important is that you are clear what the valuation number is telling you about the company and what factors can influence this valuation.
You can also use yield or times ratios, which ever ratio you find easier to understand.
For example, the Price to earnings ratio provides a quick, easy but rough valuation of a company that would leave out important information such as capital structure.
EBIT and EBITDA can provide fair idea of cash flow, and EBITDA, although less accountant friendly, can help value special companies that might include loss making, high debt and capital-intensive companies with a lot of depreciation.
Enterprise value gives you a better idea of the current value of a company as it takes its capital structure into consideration.
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