EV/EBIT Ratio Trumps P/E Ratio

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.

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22 thoughts on “EV/EBIT Ratio Trumps P/E Ratio

  1. kungfu panda

    thanks very much for the post…

    Greg, just wondering, are you aware of any stock screener that has the EV/EBIT constraint/field?

    Reply
  2. Greg Speicher Post author

    kungfu panda, the only screen that I am aware of that does this is the magic formula at http://www.magicformulainvesting.com. This also includes a screen for return on tangible capital employed so its not a pure screen for EV/EBIT. This is a great place to search for investment ideas because the EV/EBIT ratio tells you if the business is cheap and the EBIT/(Tangible Capital Employed) ratio tells you if it is a good business.

    Reply
  3. Greg Speicher Post author

    Tony B., as a general rule you should avoid companies with weak balance sheets. A business may have a reasonable debt level and still be an excellent company. It may also have considerable cash on its balance sheet. Market capitalization which is the numerator in the P/E ratio does not include the balance sheet items and can therefore distort the true cost of buying a company. The P/E ratio also does not allow you to compare companies with different tax rates without making an adjustment. All of these metrics – P/E, EBIT, EV, etc. – are tools to understand the economics of a potential investment. It is important to use the bets tools to get to this understanding and to remove any accounting items that mask the true economic performance of the business.

    Reply
  4. Johnson

    EV/EBIT is a misleading oversimplification that leads to poor decisions in many cases.

    Exhibit A: CheckPoint Software CHKP
    This operationally very successful, management controlled software company has piled up cash so that more than 1/3 of the B/S is cash. They refuse to pay a dividend. The company hence has a lazy balance sheet. Removing that cash in your EV calculation, you effectively both overstate the return that you will receive as an investor and understate the valuation of the stock.

    Thinking like an acquirer of the whole business, as is often recommended, makes sense if you can do it or influence mgmt as an activist shareholder. It does not make sense here because you cannot liberate that cash from the balance sheet. You have to pay for it in the equity, and it sits there diluting your returns.

    Plain old RoE and P/E are superior tools in this and any lazy balance sheet case (and there are a lot of them around).

    Reply
  5. Greg Speicher Post author

    Johnson, thanks for the comment. It was in reference to this type of situation that I mentioned the idea (from Joel Greenblatt) of making a judgment about whether to give full credit to the cash on the balance sheet. CHKP may not deserve credit for their cash if they are not going to use it in a way that creates value.

    Reply
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  10. Waldir

    “pay 7x EV/EBIT for a good business” doesn’t sound right. In this case, high EV/EBIT would yield higher fair prices. Shouldn’t it be the other way around, i.e., for two companies with identical EV, the one with higher EBIT and therefore lower EV/EBIT should be worth more, shouldn’t it?

    Reply
  11. nemo

    Prof Stephen H. Penman did a study of selected valuation multiples over the years 1963-2003. The analysis is summarised in Table 3.3 of “Financial Statement Analysis and Security Valuation” (5th ed).

    In terms of EV/EBIT, Penman found that only 25% of companies had an EV/EBIT ratio of 6.6x and only 5% of companies had an EV/EBIT ratio of 3.3x. (The details are not available, but it’s probably the case that Penman didn’t adjust for excess cash, maintenance capex, etc.)

    Anyway, as to WEB’s comments cited above, it looks to me that this approach would pick up companies which are fairly cheap while having much better than average growth.

    In my own work, I tend to do the EV/EBIT calculations with adjustments which differ from those noted in your post. The main ones are: 1) While it is difficult to estimate what cash is excess to requirements, I usually assume that the minimum cash level is equal to either net quick assets or say 45 days worth of the ‘payments to suppliers & employees’ figure shown in the last annual cash flow statement. 2) I rely on the average of EBIT over the last 3 financial years (ie, not just the last year), but I make adjustments if the depreciation charges are inadequate (given actual capex over those years) and to otherwise exclude accounting fictions. Generally speaking, I make these and other adjustments based on what appears in ‘Security Analysis’ (3rd ed) – which is my bible.

    This is a fascinating topic and I hope you write some more on this area.

    Reply
  12. Panos

    On its own EV/EBIT tells you that you can buy a company on the cheap but not whether that company generates good return on capital. The company might be doing badly and the market might have recognized that and pushed the price down faster than earnings have. Thus you could end up with a value trap as earnings keep coming off.

    Greenblatt’s formula by weighing 50% EV/EBIT and 50% the ROC guides you to buy cheap but also good companies. It could be smoothed out by calculating EBIT the same way that Schiller does for his CAPE and also use an average ROC rather than current.
    Any formula in my opinion should be followed by individual examination of the company as it might have had a one off gain that has pumped up earnings. I think EBIT is not the same as Earnings from operations as sometimes is called.

    I am not sure I agree with Greenblatt regarding intangibles. The aim of subtracting intangibles is to focus on the return of the capital that the CEO/Manager handles. So subtracting goodwill makes sense , but I am not clear as regards to other intangibles like brand/trademark/copyright should be excluded as those help the manager produce superior earnings.

    In periods of low interest rates EV will make a company look more expensive relative to P?E as the numerator is increased by a higher percentage than the denominator and vice versa.

    As regards to future return , I think it should be the freecash flow rate ( after all expenditures for maintenance and capital expenditures) plus growth , which should be the return on equity on the the capital expenditure part.

    Reply
    1. nemo

      Panos,

      I agree with your point about intangibles. My approach is to exclude all goodwill from the calculation and all intangibles which arise from business acquisitions (on the basis that such items are akin to goodwill).

      For example, it’s fairly common to book a figure for “customer contracts” in relation to a business acquisition which is then amortised over the term of the relevant contracts. I would normally exclude the amortisation charge from the EBIT calculation and ignore the balance when calculating the ROIC.

      On the other hand, when it comes to intangibles such as computer software, I would not adjust the EBIT calculation to exclude the amortisation charge.

      Cheers,

      Reply
  13. Hari

    Thank you Greg for explaining the EV/EBIT ratio. It really helped me internalize this ratio and hopefully will help in my analysis of businesses. here are some of the other ratios value investors consider and hope to see more on these on your blog in future.

    Enterprise Value / EBIT
    Market Cap / Operating Earnings
    Market Cap / Free Cash Flow
    Market Cap / Book Value

    thanks
    Hari

    Reply
  14. Rutvik Karve

    Great article! I have read quite a number of explanations, but I still prefer Net Profit to EBIT. As Buffett says, if tax and interest are not expenses, what are they?

    Agree that interest expense should perhaps be excluded from earnings (still not fully convinced), but tax too? Isn’t the tax rate an important consideration of expense? Perhaps to compare across industries it is necessary to deduct it and only look at purely operational earnings, but I am still not fully convinced. Your thoughts?

    Reply
  15. Shiraz

    The EV/EBIT, together with multiple (over 40) additional ratio’s, including EV/EBITDA, EV/FCF, P/E, EV/Book, Debt/Equity, etc., are available 100% free at tradepilot – there is no login/signup required – just start using the site – also includes full stock screener and industry-peer ranking, as well as in-depth company data and interactive stock charts. Best regards, Shiraz Lakhi (Founder)…

    Reply
  16. bargainvalue

    Hi,
    I have tested the EV/EBIT on the LSE lately. Some regularity can be found when you use this indicator for the construction of your investement strategy, but the results are not so clear as for P/E ratio. I agree, that EV/EBIT measures the true value of the company more reliably, however P/E is better for creating high profitable portoflios.

    You can check my results here:
    http://bargainvalue.co.uk/is-evebit-a-good-indicator-of-cheapness/
    http://bargainvalue.co.uk/is-priceearnings-indicator-useful-for-creating-high-profitable-portofolio/

    Reply

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