Investors should make the ratio of a company’s enterprise value (EV) to its earnings before interest and taxes (EBIT) a primary tool to evaluate its earnings power and to compare it to other companies. This is the ratio that Joel Greenblatt uses for his magic formula and that Buffett appears to use when evaluating a business.
The P/E ratio is useful as a crude screening tools but it has serious limitations. One such limitation, which the EV/EBIT ratio addresses, is that the P/E ratio does not take into account the balance sheet and, as a result, it can materially misrepresent the earnings yield of a business.
To take a very simple example, imagine that you were considering the purchase of a commercial lawn care business in your town and you had narrowed it down to two candidates. Business 1 has an asking price of $500,000 and earnings of $100,000. Business 2 has an asking price of $700,000 and earnings of $100,000. Business 1 looks like the better bargain with a P/E ratio of 5, compared to a P/E of 7 for business 2.
The problem is that without looking at the balance sheet you cannot reach a conclusion about which business is cheaper. Going back to our example, further imagine that business 1 has a bank loan for $200,000 and business 2 has a Certificate of Deposit worth $200,000. In that case, you’d really be paying 7x earnings to purchase business 1 and only 5x earnings to purchase business 2, the exact opposite of the conclusion reached by not taking the balance sheet into consideration.
Although the preceding example did not make the distinction, EBIT is also superior to GAAP earnings in that it eliminates distortions and differences arising from different tax rates.
EBIT itself is also a short-hand measure of sorts in that, without further adjustment, it assumes that a company’s expense for depreciation and amortization is equal to its expense for maintenance capital expenditures (capex). Greenblatt’s Magic Formula makes this assumption in order to simplify the calculation required for the selection of stocks. This provides an opportunity for investors who wish to improve upon the magic formula’s mechanical approach by doing further business analysis.
This assumption can distort a business’s true earnings yield and the comparison of its earnings yield to that of other businesses. The growth portion of capex in a growing business may materially understate EBIT if a distinction is not made between growth capex and maintenance capex. It is very useful to be able to evaluate what the business would look like in a steady state so you can see how cheap it is and how it compares to other opportunities.
To get a more accurate view of a business, you should calculate EBIT by subtracting actual maintenance capex from EBITDA. If a business does not disclose its maintenance capex, you can usually derive it by making some reasonable assumptions.
Interestingly, regarding the calculation of intrinsic value, some investors use EBITDA – maintenance capex in their calculation of earnings power and in their discounted cash flows, giving full credit for the free cash used to reinvest and grow the business. My own thought is that this approach can make sense if the returns on the reinvested growth capital clearly exceed the cost of capital and are therefore value creating.
Buffett was asked at the 1998 Berkshire shareholders meeting how he estimates intrinsic value for companies where the free cash flow is largely offset by reinvestments to grow the business. The shareholder specifically mentioned McDonald’s and Walgreen’s as examples. Buffett, in seeming contrast to the approach mentioned above, said that he only gives credit for the cash that is left after growth capex. He figures that if the investments are made wisely the growth in future free cash flows should more than offset the discounted value of those cash flows. If it does not, Buffett figures it was not a good use of that cash.
Buffett reiterated his view that the best kind of business is the one that grows free cash with little or no-reinvestment, although he stated he is also quite happy to own a business that requires reinvestment of capital but provides a satisfactory rate of return on that reinvestment.
EV is superior to market value as a measure of how much you’re really paying for a business because it includes not only the cost of the company’s equity but also the cost of the company’s debt. It also gives the company credit for its cash, which can be used to offset the purchase price – for example, through a special dividend – or to retire debt.
Bruce Greenwald recommends not subtracting 100% of the cash but leaving an amount equal to 2% of revenues for use as working cash. I have also seen Joel Greenblatt comment that he won’t just assume that the cash is worth full value. He analyzes the situation and may give cash only partial credit depending on his judgment of how it will be used.
It is always fascinating to me when I find a stock that does not look particularly cheap when I look at its P/E ratio that turns out to be cheap when I calculate its EV/(Adjusted EBIT). I strongly suggest that you make this a part of your analysis of any potential investment.
Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.
If you wish to learn more, please see the appendix to The Little Book That Beats the Market by Joel Greenblatt and Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald et al.