Session 16: Other Earnings Multiples

Introduction

In this session, the speaker discusses enterprise value multiples and how they are used in acquisition valuation and equity research. The focus is on the enterprise value to EBITDA multiple.

Enterprise Value Multiples

• Enterprise value is the market value of equity plus debt minus cash.

• Equity earnings multiples have been replaced by enterprise value models.

• The most logical measure of enterprise cash flow is free cash flow to the firm.

• Enterprise value to EBITDA is a widely used multiple in many sectors of equity research.

Computing Enterprise Value to EBITDA

• Enterprise value to EBITDA is computed as market value of equity plus debt minus cash divided by EBITDA.

• Netting out cash from the numerator is done for consistency reasons since income from cash is not part of EBITDA.

• Consistency with EBITDA can be difficult due to cross holdings and minority interests.

Rules of Thumb

• Enterprise value to EBITDA multiples are notorious for rules of thumb.

• Six times EV/EBITDA may not always be a good measure of cheapness or expensive depending on market conditions.

Understanding Enterprise Value Multiples

In this section, the speaker explains how to calculate enterprise value multiples and what variables drive them.

Calculating Enterprise Value Multiples

• The value of a firm is the expected free cash flow to the firm divided by the cost of capital minus growth.

• Free cash flow to the firm can be written as EBIT times 1 minus tax rate plus depreciation tax benefit minus capex minus change in working capital.

• The drivers of EV/EBITDA for a stable growth firm are: tax rate, expected growth rate, cost of capital, and efficiency in delivering growth.

Variables that Drive EV/EBITDA

• Tax rate: A higher tax rate leads to a lower enterprise value for a company.

• Expected growth rate: Higher growth rates lead to higher EV/EBITDA multiples.

• Cost of capital: Riskier firms have higher costs of capital and lower EV/EBITDA multiples.

• Efficiency in delivering growth: Higher reinvestment rates lead to more capex and change in working capital, resulting in lower EV/EBITDA multiples.

Example Calculation

• For a simple company with a 36% tax rate, 30% capex, 20% depreciation, stable growth, no working capital requirements, and a cost of capital of 10%, the intrinsic EV/EBITDA multiple is 8.24.

• This hypothetical example shows how changing one variable at a time affects the EV/EBITDA multiple. For instance, changing the tax rate from 0% to 50% changes the EV/EBITDA multiple from more than 16 to less than 7.

Using EV/EBITDA Multiples

• When evaluating a company based on its EV/EBITDA multiple, it's important to consider variables such as tax rate, return on capital, reinvestment rate, growth rate, and cost of capital.

• Look for a mismatch of low EV/EBITDA with none of the variables that should cause a low EV/EBITDA.

Trucking Companies and Writer Systems

In this section, the speaker discusses a table of trucking companies and focuses on one company that looks interesting - Writer Systems. The speaker explains that Writer Systems rents out trucks for people to move themselves and has been around for a long time. However, the speaker also warns about being cautious when investing in trucking companies due to their strange investment practices.

Investing in Trucking Companies

• Trucking companies invest in a strange way - they don't reinvest for years and then replace their entire fleet.

• It's important to be careful about both the timing of your investment and secondly, the age of the assets you're looking at.

• Infrastructure companies, in particular, use a lot of debt to fund the next expansion or replacement of their fleet.

Writer Systems

• Writer Systems is trading at 2.91 times habita which makes it look cheap.

• However, it had the oldest fleet in this sector which means it may not be as cheap as it seems.

• Be cautious when investing in trucking companies like Writer Systems.