ABOUT BLOG STORE  RESOURCES 

How to Value Stocks? – P/E or EV/EBIT?

How to Value Stocks? – P/E or EV/EBIT?

 kelvesy    Blog Thinking    July 12, 2018  |  8

What is P/E or EV/EBIT?

Value investing is one of the ways to compound your wealth. Starting out as an investor, the common valuation metric I use is price-to-earnings-ratio (PER). This is a very
simple approach of taking the “share price divided by the earnings per share”. It can be calculated using “market capitalization divided by the net pro t after tax”. It means
the same thing.

Company A Company A

Market Cap $100m Share Price $50

Net Pro t After Tax $10m Earnings Per Share $5

P/E 10x P/E 10x

Using the above table, we assume that Company A has two million shares in the company. When the share price is $50, to nd the entire market capitalisation of the
business, we multiply the share price with the total number of shares. $50 x 2m = $100m. Likewise, to nd the earnings per share of a company, you can take the net pro t
after tax divided by 2m which you will get $5 ($10m / 2m). It is all the same.

However, I realised that it may not provide me with the most accurate valuation of a company. It does not take in consideration the debt or cash position of the company. It
could be a very fatal mistake to commit especially when you think you’ve found an undervalued company based on P/E.

Introduction of EV/EBIT

EV/EBIT is a slightly more advanced valuation method and I will do my best to explain. It can be very simple as well!

Enterprise Value divided by Earnings Before Interest, and Taxes (EBIT).

Why EBIT and not net pro t after tax? In some companies, net pro ts could be distorted by exceptional items such as valuation gains of non-core activities, restructuring
costs or impairments. You may not want to value a company based on non-recurring income!  Let me share what is non-recurring income.

Company A FY2017 FY2018 Change

Reported Net Pro t $10m $8m -20%

Minus: Disposal of Property $4m $0 NA

Adjusted Net Pro t $6m $8m +33.3%

Using Company A as an example, an ordinary investor would think that the company’s net pro t has dropped from $10m in FY17 to $8m in FY18. However, looking deeper,
company A sold a property for $4m in FY2017. We do not expect Company A to sell a property every year so we will consider it as non-recurring income.

The real underlying pro t for FY2017 should be $6m ($10m – $4m). With better clarity, we know that the company A did better with $8m pro t in FY2018. We are interested
in the core earnings of the business.

Therefore, EBIT is a far better approach to assess the earnings accurately, excluding the factors of tax and nance expenses. EBIT is derived from deducting operating
expenses from a company’s gross pro ts.

Here is Apple’s FY2017 income statement where I highlighted the operating income.
 ABOUT BLOG STORE  RESOURCES 

Why enterprise value, and not market capitalization? Imagine that a prospective buyer is keen to acquire the entire business from the stock market, does he pay the
amount equivalent to the market capitalization of the business? The true answer is no. The prospective buyer takes on the debt or cash that comes along with the
business. It may be higher or lower.

To determine the true value of the business, we need to use enterprise value.

Enterprise value = market capitalization + total debt – total cash and cash equivalent

Using 3 simple companies, assuming they earn the same amount of earnings, which company would you buy?

Company A B C

Market Capitalisation $200m $200m $200m

Total Debt $0 $50m $0

Total Cash $0 $0 $50m

Enterprise Value $200m $250m $150m

The answer is…. company C!

Using enterprise value as a guide, you can see that the true price tag for Company C is the lowest. When someone forks out $200 million for company C, he is paying out
$150 million only! Why? By acquiring the company at $200 million, he gains access to a cash pile of $50 million. Therefore, the true price tag for the business is $150
million!

The calculation goes like this…. $200 million (market capitalization) + $0 (total debt) –  $50 million (total cash & cash equivalents)

To put things in better perspective,

Enterprise value = market capitalisation + total debt – total cash

EV / EBIT = enterprise value divided by EBIT

P/E = market capitalization over net pro t after tax

Company Facebook Ford

Market Capitalisation $561b $41b

Total Debt $0 $154b

Total Cash $42b $26b

Enterprise Value $519b $169m

EBIT $20b $5b

Net Pro t After Tax (NPAT) $16b $4b

P/E 35x 10.3x

EV/ EBIT 25.6x 33.8x

*the gures are not actual gures

You will see that, despite having a low P/E ratio, Ford’s share price had remained downtrend for the last 4 – 5 years. Why? An astute investor would investigate Ford’s debt
and be worried. Taking its debt into consideration, EV/EBIT turned out to be 33.8x which is high!

(captured from Google Finance on 9 July 2018)

On the other side, Facebook has a P/E ratio of 35x yet its EV/EBIT 25.6x. For a high growth company like Facebook, the valuations are not too expensive.

Hope this article provides greater perspective. When the P/E is too high or too low, perhaps, consider using EV/EBIT to get a better assessment of the price-multiple!

Summary:
 The Enterprise Value considers cash and debt amount to reveal a true price tag for a listed business.
The operating income (EBIT) removes e ects from non-recurring items and di erent tax rates ABOUT BLOG STORE  RESOURCES 
The EV/ EBIT ratio provides more clarity compared to P/E ratio.

Now you have understood what is the differences between EV/EBIT and P/E, how about understanding the Power of Gross Margins?

Share this:

 
Like this:

Like
2 bloggers like this.

Related

What Drives Your Stock Returns? Investment Re ections for 2018 Power of Gross Pro t Margins
July 16, 2018 December 26, 2018 May 18, 2018

  APPLE EV/EBIT FACEBOOK FORD IMPAIRMENT MARKET CAPITALISATION P/E PRICE TO EARNINGS

 Previous: Sustainability of Dividends Next: What Drives Your Stock Returns? 

8 Responses

mslee888
July 12, 2018 at 5:05 am

Is it better to use EV/EBIT or EV/EBITA? SGX Stockfacts provide this EV/EBITA ratio, so it is easily assessible. Thanks

mslee888
July 12, 2018 at 8:54 am

Sorry, unable to edit comment. What i meant was EV/EBITDA.

Kelvin Seetoh
July 13, 2018 at 1:46 am

In my view, EV/EBIT is more stringent. EBIT is easily computed by taking Gross Pro t minus SGA costs.

In my view, “DA” is a real cost to the business. While it is non-cash, the biz would need to spend approximately the same amount to cover
and replace the PPE in the future.

However, it may not capture fast growing companies with growing depreciation.. such as HaiDiLao.

mslee888
July 13, 2018 at 3:14 am

Thanks for yr advice. Will use both ratios for assessment in future.

WN
July 13, 2018 at 4:34 am

Usually people would advice PE be in the range of 12 or 15 as a guide. Is there a guide for ev/ebit? Thanks.

kelvesy
July 13, 2018 at 4:40 am

Increasingly, I found companies trading at PE 12 – 15 are companies that are not high quality and their earnings may not grow reasonably. This
could be 1) the business model is not competitive 2) the management did not position the company correctly 3) the industry is easily a ected by
macro-economic trends.

The key of my investment philosophy is to search out strong companies with strong management. Look at Facebook. At PE 20, by traditional
metrics, you would consider it expensive. But it has since grown really well. I am using Facebook and Instagram to reach out to people. at PE 20, it
is cheap.

What is cheap or expensive depends on the quality of the business you buy. You can buy something cheap but it will become cheaper. Focus on
the quality of the business, you will do really well.

WN
July 13, 2018 at 5:13 am

Thanks for your reply. Noted and agreed to focus on quality buz.

Do I compare the ev/ebit with the market average to determine whether it is high or low? How do I tell whether the ev/ebit is high or low or
acceptable? Thanks.

W h a t D r i v e s Yo u r S t o c k R e t u r n s ? | K e l v e s t o r
July 22, 2018 at 1:48 pm

[…] that you’ve understood PE ratio, try to explore and understand EV/EBIT which is a better valuation […]
 Comments are closed.

ABOUT BLOG STORE  RESOURCES 

Search …

F O L LOW M E O N FAC E B O O K

Kelvestor.com
2.4K likes

Liked

You and 4 other friends like this

S U B S C R I B E T O K E LV E S T O R

Name

Email address:

I understand and accept your Privacy Policy.

SUBSCRIBE

TO P CO M M E N TS

CA Hau on Watch Where The Money Goes

kelvesy on Two Quick Pointers

kelvesy on Watch Where The Money Goes

CA Hau on Watch Where The Money Goes

Vincent Wong on Two Quick Pointers