P/E, EV/EBITDA, EV/EBIT, P/FCF – When to use what ?

This post was prompted by a minor change in the standard Bloomberg company description which I noticed over the last view months. If one uses the function “DES” Bloomberg provides on page 3 some standard ratios which are quite helpful in order to get a first view on a company. Within the screen there are 6 boxes, the upper left box showing currently the following ratios (example: National Oilwell Varco, NOV US):

Issue Data
~ Last Px USD/80.91
~ P/E 14.4
~ Dvd Ind Yld 1.3%
* P/B 1.60
~ P/S 1.5
~ Curr EV/T12M EBIT 8.6
~ Mkt Cap 34,637.6M
~ Curr EV 35,743.6M

Interestingly, a few weeks ago (??), one would get EV/EBITDA instead of EV/EBIT. I am not sure why they changed it, but it is a good starter in order to think about the differences between P/E, EV/EBITDA and EV/EBIT

The P/E ratio

The P/E ratio is clearly the most famous valuation ratio. A low P/E strategy still seems to work. In my opinion, the P/E ratio clearly has two major fundamental drawbacks as a “strong” criteria for me as a stock picker:

– it does not reflect net debt or net cash
– under IFRS, many items (Pensions, currency changes) are booked directly into equity. This is the reason why I prefer P/Comprehensive income

EV/EBITDA Ratio

The “classic” EV/EBITDA ratio is much better in capturing debt and net cash than the P/E. As I have explained in an earlier post, one should be careful with EV in certain cases (leases, pensions), but overall, EV is much better to compare highly leveraged companies with “conservative” companies

EBITDA, as the name says, is “Earnings before Interest, Taxes, Depriciation and Amortization”. Some people have called it “Earnings before everything else” but in theory, EBITDA should be a proxy for operating cashflow.

As I have written before, this metric has been used a lot by Private equity buyers in order to assess, how much debt could be pushed into a company unitl it chokes.

In the latest edition of O’Shaugnessey’s “What works on Wall Street”, EV/EBITDA is also one of the strongest single factors, much better than P/B and P/E.

The problem with EBITDA is that although it might approximate Operating Cashflow, it does not equal “free cashflow”. The “D” in EBITDA means depreciation. If you leave out depreciation, the effect will be that capital-intensive businesses which need a lot of capex (and depreciation) look suddenly quite good, although this cashflow never reaches the equity holder, because it is necessary to maintain the productive capital.

We can see this easily if we look at the DAX companies, sorted by EV/EBITDA:

EV/EBITDA T12M
Deutsche Lufthansa AG 3.26
RWE AG 3.51
K+S AG 4.33
Continental AG 4.78
E.ON SE 4.80
Deutsche Telekom AG 5.85
ThyssenKrupp AG 6.27
HeidelbergCement AG 6.82
Volkswagen AG 6.93
LANXESS AG 7.25
Bayerische Motoren Werke AG 7.26
Deutsche Post AG 8.19
Infineon Technologies AG 8.19
Fresenius SE & Co KGaA 8.74
BASF SE 8.82
Bayer AG 8.97
Linde AG 9.10
Merck KGaA 9.12
Fresenius Medical Care AG & Co KGaA 10.33
Siemens AG 11.05
Henkel AG & Co KGaA 11.46
Adidas AG 11.85
Daimler AG 11.86
Deutsche Boerse AG 13.64
SAP AG 13.93
Beiersdorf AG 15.59

The cheap stocks are those companies, which are REALLY capital-intensive. Clearly, RWE and EON need to continuously reinvest into their huge power stations or they will not be able to produce any electricity soon. On the other hand, Deutsch Börse is basically a market making software with some computers and a government license. Very few assets, small depreciation.

So the “difference” between low EV/EBITDA and HIGH EV/EBITDA is not necessarily “cheapness” but different levels of capital intensity

EV/EBIT

This is why many “professionals” prefer EV/EBIT to EV/EBITDA. EBIT already deduces depreciation and should therefore be a better proxy for Free cashflow than EBITDA.

Let’s look at the Dax companies sorted by EV/EBIT:

EV/T12M EBIT EV/EBITDA T12M P/E
SDF GY Equity 5.7 4.3 7.7
CON GY Equity 7.5 4.8 13.4
EOAN GY Equity 7.5 4.8 11.0
RWE GY Equity 7.9 3.5 22.4
FRE GY Equity 11.2 8.7 17.9
HEI GY Equity 11.2 6.8 34.2
TKA GY Equity 11.3 6.3 N.A.
DPW GY Equity 12.3 8.2 16.3
BAYN GY Equity 12.7 9.0 24.7
BAS GY Equity 13.0 8.8 14.9
FME GY Equity 13.4 10.3 19.8
HEN3 GY Equity 13.6 11.5 22.7
LXS GY Equity 13.6 7.3 24.5
BMW GY Equity 13.9 7.3 10.2
DTE GY Equity 14.3 5.8 N.A.
DB1 GY Equity 15.8 13.6 19.8
VOW3 GY Equity 16.0 6.9 10.4
SIE GY Equity 16.2 11.0 17.0
LHA GY Equity 16.2 3.3 8.7
MRK GY Equity 16.6 9.1 25.6
LIN GY Equity 16.7 9.1 19.4
SAP GY Equity 17.0 13.9 22.1
BEI GY Equity 18.3 15.6 32.2
ADS GY Equity 18.6 11.9 31.8
DAI GY Equity 19.2 11.9 8.5
IFX GY Equity 22.5 8.2 28.6
 
avg 13.9 8.5 19.3

I have added also EV/EBITDA and P/E in this table. It is interesting that P/Es look rather random when we sort by EV/EBIT. Especially Lufthansa looks now really expensive as well as Daimler and Infineon. On the other hand, a relatively expensive looking stock like Fresenius now looks rather cheap. A company like Beiersdorf looks expensive in any metric and th utilities look still cheap but not Deutsch TeleKom.

For the utility stocks for instance I think EV is too low, because one needs to add the liabilities for decommissioning the Nuclear plants to EV.

A quick word on Free Cash flow and P/Free cashflow ratio

As I have written earlier, one really has to be carefull with reported free cash flows. Cashflow statement are not really audited and it is quite easy to “massage” the categories. Free cash flow is clearly an important number to look at in a second step, but as a standard indicator it has very limited use in my opinion.

Some additional pitfalls

Using EV/EBITDA and EV/EBIT smoetimes can also be tricky. Among others are operating leases, pensions, certain prepayments etc. which can change EV dramatically. But there can also be issues on the EBIT/EBITDA side:

For instance, those are the stats for Statoil ASA, the Norwegian Oil company:

P/E 11.8
EV/EBITDA 2.2
EV/EBIT 3.3

From an EVEBit perspective, this clearly looks like a no brainer: we only pay 3 times EBIT for a rock solid oil and gas company. Well, but we might have forgotten one important thing: Between EBIT and Free cash flow we have still two other items: Interest and Taxes.

As Statoil doesn’t pay much interest (only 2% of EBIT) the issues is clearly taxes. Statoil is subject to special taxes, which on average amount to 75% of EBIT. There might be some leeway to shelter certain tax payments, but in a country like Norway the companies will have to pay most of those taxes in cash.

Interest and Taxes are especially important if one compares companies across different countries. All other things equal, companies in high tax rate countries with high taxes will trade at lower EV/EBIT and EV/EBITDA multiples than in low tax low-interest rate countries. So fo instacne the Swiss MArket Index trades at 16.7 x EBIT and 12.2 EBITDA significantly higher than the German index. At least part of that is due to the much lower tax rate in Switzerland and even lower interest rates.

So a comparison of peer companies across countries with very different tax rates ind interest rates should not solely be based on EV/EBIT or EV/EBITDA.

Other issues with EV/EBIT and EV/EBITDA – financial companies and financing business

EV measures usually don’t work well with financial companies and also companies which have a lot of financing business on their books. Originally, EV is meant to capture “real” leverage, i.e. debt issued to pay for machinery, inventory etc. Debt issued to fund for instance client purchases is referred to as “operating” leverage. It is a little bit a grey area. Clearly, one should prefer a company which sells only stuff against cash than financing it for several years. The financial crisis in 2008 has shown that such “operating” leverage quickly became “strategic” if the roll over doesn’t work. On the other hand, in normal times operating leverage could be potentially adjusted against EV as you have “extra assets”.

If one tries to compare financial companies vs. industrial companies though, P/E is clearly more useful, as financial companies per definition have much higher EVs than non-financial companies.

Price /Comprehensive income

This is a ratio which I use especially for financial companies. Comprehensive income inlcudes all kind of “value changes” which are booked directly against equity, such as changes in the value of pension libailities, value changes of financial assets including hedges, currency translations etc. Especially for financial companies, comprehensive income is a pretty good leading indicator although it is rarely used in my experience.

Summary:

In general, I would recommend to look at all “Popular” ratios in parallel, because it gives a better “multi dimensional” view on a company. For “Normal” company, in my opinion, EV/EBIT is the most significant ratio, followed by P/Comprehensive Income.

P/Es and Ev/EBITDA are clearly also helpful. The most interesting cases are those, where the different ratios are completely different. This is often an indicator for somthing “special” going on and potentially a stock to investigate further.

In any case, although I like EV/EBIT, one should always “look down” in the P/L to the real bottom line (comprehenive income) as good CFOs are quite creative in moving expenses “down” the chain where many people don’t bother to look any more.

Finally as a special service, an overview over the different ratios and when to use them:

15 comments

  • How about EV/FCF? (ideally unlevered FCF but tricky to figure out effective tax rate)

  • Great article. I really regret, that I hadn’t found this before I had published my material about EV/EBIT. I would surely partein to it, because it is very informative. I’ve tested how useful can be this indicator for creating high profitable portfolio on the LSE. Moreover, I have conducted similar test for P/E ratio. You can check it here:
    http://bargainvalue.co.uk/is-evebit-a-good-indicator-of-cheapness/

    After reading your work, I have an idea to compare all three indicators: P/E, EV/EBIT and EV/EBITDA and concentrate more on the differences between comapanies results on the level of balance sheet.

  • Did you realize, that also Warren Buffets main investment hurdle seems to be close to EV/EBIT?
    His demand of at least 10% yield on pre-tax invested capital sounds like EV/EBIT <10.

    Reading this blog posting and discussion I instantly got reminded on your great posting.
    http://oddlotinvest.wordpress.com/2014/03/07/midas-reveals-his-touch-the-one-rule-to-rule-them-all/comment-page-1/#comment-84

  • Pingback: Aurubis Teil II – Bewertung | Gier ist gut

  • “For the utility stocks for instance I think EV is too low, because one needs to add the liabilities for decommissioning the Nuclear plants to EV.”

    Üblicherweise sind die Abbaukosten bei erstmaligem Ansatz Bestandteil der AHKs – zumindest nach IFRS.

    Die Kosten werden geschätzt und über die Laufzeit des Kraftwerks abgeschrieben. Zu finden in IAS 16.16c

    Ansonsten ein sehr guter Artikel!

    Viele Grüße

  • Actually, the statement of cash flows is audited, “hard” or “soft” in exactly the same way as any other IFRS statement. The rules of classification are quite clear and enforceable.

    Also, cash is a problem for EV. Different companies have quite different cash needs or at least policies, and subtracting cash from the balance sheet can be very misleading.

    Great post though!

    • well, the problem is that an “audit” of a cashflow statement is not the same as the audit of the “doubly entry” accounts. There is no “cash account plan” or something similar.

  • This is a good post. I have some more pitfalls, at least for me:
    -adjusting for minority interest (e.g. all Indian companies 🙂
    -adjusting for non-recourse debt (e.g. Asta Funding)
    -adjusting for off-balancesheet stuff in general (very tricky and individual)
    -adjusting for different divisions (sum of parts is better if some subsidiaries post a loss)

    After adjustments I like EV/Ebit or EV/NOPAT best.

  • Nice post again. I can’t help but noticing every few posts that you seem to use a Bloomberg Terminal. These are quite expensive right? Approximately 30k/year? Do you have one at work? Is this your work? Or do you have such a large portfolio that it’s not a drag on your returns 🙂

  • What do you mean by “Cashflow statement are not really audited” ??

    Great content and info on the blog. Thanks

  • Agree on use of EBIT over EBITDA, ESPECIALLY (and really, necessarily!) when comparing across sectors! Other metrics that I often use as well include EBITA (after D, but before amortization of non-recurring intangibles), EBITDA-MCX as professed by many but takes a bit more work (should generate results similar to EBITA or EBIT for a clean company), or NOPAT = EBIT*(1-TR), alternatively (EBITDA-MCX)*(1-TR) — either of which will correct for disparities in tax regimes. The beauty of all of the post-capital spending metrics is that they can be readily compared to a discount rate and therefore capitalized whereas EBITDA yield is a relatively meaningless statistic.

  • Came here to say beware of EBIT but you stole my thunder by mentioning Statoil. Good job!

    I have been building my own screener based on Greenwald’s Earnings yield and ROIC. He uses EBIT in his calculations. This screener consistently rated Statoil at the top. But it doesn’t make sense because taxes can’t be avoided. Later I realised that he screened only american shares which meant all had more or less the same tax rate.

    I started to use EBI (earnings before interest, after taxes) and try to be very conservative when calculating debt (thus including also pension liabilities etc.). Will have a look at what comprehensive income does.

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