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Demystifying enterprise value to pick stocks

Hari Viswanath BL Research Bureau | Updated on October 24, 2021

Successful investing is built on a solid foundation of valuation. Here, we demystify enterprise value based multiples to help you zoom in on the right stocks

When it comes to valuation, beauty is always in the eye of the beholder. For example, if you take the stock that is among those that have grabbed the most attention globally over the last one year — Tesla — its value, as seen by Wall Street analysts, ranges from $250 to $1,200, when it is currently at $909. While many Wall Street analysts saw only single-digit share price for GameStop, retail investors saw its worth to be in triple digits. The targets for Reliance Industries range from ₹1,430 to ₹3,250. Who amongst them is right? Only time will tell.

This clearly indicates that while successful investing requires a strong temperament, good judgement, decent timing, and some element of good luck, all these need to be built on the solid foundation of valuation.

Valuation based on common metrics such as Price to Earnings (PE) and Price/Book (P/B) is well known. In our Portfolio edition dated October 10, we had explained how one can use earnings yield (1/PE) (https://tinyurl.com/52c6a85e and https://tinyurl.com/e92wt4ey) as a valuation metric too, as it enables easier comparison of investment opportunity across asset classes. Here, we explain some Enterprise Value (EV)-based metrics that you can use to choose an investment.

 

EV-based valuation

EV refers to the total value of a firm/company. A company belongs to its equity shareholders. However, whatever claim they have in the value of a business is only after paying/providing for third party liabilities (bank/bond holders) – primarily the net debt (total debt minus cash/bank balances). In other words, one can say the total value of a company, as perceived by the market, is the sum of its market cap plus net debt.

What are the advantages in using EV-based metrics versus equity-centric metrics like PE and P/B? What works in the case of EV is that it helps in doing a capital-agnostic analysis of a company. Whether a company is funded only with equity, or a combination of equity and debt, the total value of the business is the same. Sources of funding don’t matter. Using EV, the value of equity (share price) is derived from the value of the business. Since the capital structure of companies varies significantly, an EV approach enables valuing them on similar terms.

One thing that needs to be noted with EV valuation is that any change in EV will impact only the equity value. For example, if EV of a company is ₹100 and it has ₹50 in debt, then the value of its equity is ₹50. In this case, if EV increases by 10 per cent, the value of equity will increase by 20 per cent, and the reverse is also true. The higher the leverage, more the impact of change in EV on the value of the stock (both ways).

Some key EV metrics

EV/EBITDA and EV/EBIT

EBITDA is earnings before interest, tax, depreciation and amortisation and EBIT is earnings before interest and tax. As EV is capital-agnostic, it is important to exclude capital-related payments/costs like interest. Similar to using PE to value a stock, businesses can be valued as a multiple of their EBITDA or EBIT based on historical precedence, growth prospects and relative valuation of peers. The reason EBITDA is used is because it is a proxy for cash flows and reflects operational profits. It gives an idea how many years of current year cash flows are required make up for the value of the firm (market cap + net debt). Assigning the appropriate EV/EBITDA multiple has to factor for cash outflows relating to capex and taxes. Hence companies/industries with lower capex/taxes will usually get higher EV/EBITDA valuation.

Using EV/EBITDA as a metric to value stocks is common across industries where leverage is widely prevalent and businesses are capital-intensive – metals/commodities, telecom, automobiles, capital goods/cement, chemicals, etc. EBIT is used as a metric in industries where capex intensity is lower, like software, where EBIT is a good proxy for cash flows.

Besides enabling comparability of business, another use case for EV/EBITDA is that it allows for valuing companies that may be loss-making at the net profit level. Companies could be decently profitable at the EBITDA level, but end up with losses at the bottom line due to high interest costs and depreciation. PE is redundant in such cases. EV/EBITDA is a good option in such contexts if one can assess whether the companies can return to decent profitability over the next few years.

Take, for instance, Tata Motors, which has been reporting losses at the net income level in four of the last five years, while remaining profitable at the EBITDA level. If one needs to compare it with Maruti Suzuki to make an investment decision, PE-based comparison will not be possible. EV/EBITDA will be one of the ways to compare. Based on FY21 numbers, Maruti PE is 96 while it is a negative 37 for Tata Motors. However, on EV/EBITDA basis, Maruti trades at 40 times while Tata Motors trades at just 9 times. Of course, other aspects like product portfolio, pipeline, margins, growth prospects, balance sheet strength, etc, must be considered too before zeroing in on the right stock to invest in.

EV/Tonne

This is used to value cement and metal companies and assess whether they are trading above or below their replacement costs (cost of setting up a new plant). Assuming there is no structural overcapacity in the industry, if EV/tonne is cheaper than replacement cost, then it could indicate the stock is undervalued. The same metric can be used for power companies as EV/MW (megawatt). An example of how one might get a different perspective on a stock based on EV/Tonne is by comparing Ultratech and Ambuja Cements based on EV multiples. On trailing PE basis, Ultratech appears more expensive at 32 times versus Ambuja Cements at 22.5 times. But on the basis of EV/Tonne, Ultratech appears cheaper at ₹19,285 versus Ambuja at ₹24,282.

EV/FCF (free cash flow)

This is commonly used to value tech companies. Tech companies are usually cash rich and, once established, have good cash flows and low capex. Free cash flow is the operating cash flow minus capex. This is the cash that is available for distribution to shareholders or to add to cash reserves of the company. The cash reserves can be utilised for future growth investments, distribution to shareholders or as buffer for contingencies. However, one shouldn’t use this metric for businesses that may engage in capex for capacity expansion. Such companies will have years where, despite being profitable, FCF might be negative due to capex.

If one compares Infosys vs Wipro, both trade at a trailing PE of 38 times. However, on an EV/FCF basis Infosys trades at 32 times while Wipro at 25 times. While this does not implicitly mean one should choose Wipro over Infosys, it is a good additional metric to consider while valuing them.

Valuing new age companies

While the above are examples to value shares of established companies, the same may not be very useful when it comes to new-age companies that are getting listed today. Some of them are unprofitable at the EBITDA level, and even in cases where they are profitable, it is not significant, and multiples get skewed. Here are some metrics to apply to them:

EV/Sales

Growth companies can be valued as a multiple of sales, provided, the company has what is commonly referred to as ‘path to profitability’. In this, you are valuing a company based on the confidence that it will reach sustainable profits a few years down the line, and are ready to make a bet on that today. Going by the EBITDA/EBIT/PAT margins you expect the company to achieve in future, and its revenue growth prospects, you value the company as multiple of current or next one-year revenue.

While valuing on this metric, history has to be used as a guide to ensure one does not end up overvaluing a stock. Many new-age companies have been getting listed since the dotcom era in the US, and the performance of many of those stocks over the last 1-2 decades can serve as good guidance on a reasonable valuation range for such companies getting listed in India also.

New-age companies from India that can be valued on the basis of EV/Sales include Zomato and Freshworks (listed in the US). Zomato trades at one-year forward EV/sales of 21.3 while its US-based peer Uber trades much cheaper at just 4.4 times (Bloomberg). Freshworks trades 28.1 times EV/sales versus its US-based peer Salesforce trading at 9.6 times. For new-age companies, the growth rates are high whether it is the US or India. This implies that the valuation for India-based new-age companies may have crossed the upper valuation range that new-age growth companies usually trade in and some caution is warranted. For example the highest EV/sales multiple that Salesforce has traded at since 2006 is around 13 times..

EV/MAU or EV/Subscriber

LinkedIn (now part of Microsoft) was the first social media company to get listed. When this happened in 2011, the business models of social media companies were still evolving – how they would monetise their subscribers, network effect, internet properties, etc, were still unproven. Revenue trajectories were unclear.

In such times, investors resorted to valuing the companies based on EV/MAU. While the definition of Monthly Active Users (MAU) varies from company to company, at a broader level it refers to the number of unique customers who interacted with a product or service in a month. Companies still early in monetisation strategy deserve lower EV/MAU and those in more advanced stages deserve higher EV/MAU. Similarly, companies with more subscribers and stronger network effect (more dominant like Facebook) deserve higher EV/MAU while those with relatively lower network effect (like Snapchat) deserve lower EV/MAU.

The combination of the two factors determined the overall EV/MAU in the early part of the previous decade. The same can be applied to new-age companies getting listed in India. MAU/Subscribers can be replaced with the relevant metric for the company. The key here is to value a company based on the unique monetisable asset. For social media companies, subscribers were the monetisable asset. When LinkedIn hit the markets, it was priced at EV/MAU of $62; however, when Microsoft acquired it five years later it was valued at EV/MAU of $225 as the company had progressed substantially on the monetisation curve and was profitable.

Finally, never forget the most important thing when you approach valuation on the basis of EV. If the company is a net cash company, then the value of your stock is EV plus the net cash. If it is a net debt company, the value of your stock is EV minus net debt.

Rules for valuation-based investment decisions

1 Base investment decisions on a combination of valuation metrics that you deem important. For example, buying a stock just based on its PE multiple is like buying a car on its labelled engine power and not giving consideration to cost of maintenance, mileage, how it performs under stress/wear and tear, etc. Similarly when you use PE or P/B, it needs to be analysed based on historical track record of the company, earnings growth potential for the next few years, management quality, balance sheet strength, etc. For most part of the last decade, HDFC Bank was trading at a P/B above 4 times that was significantly higher than that of PSU banks like SBI (range of 0.75 to 1.75 times). Opting to avoid it based on its high P/B and buying PSU banks would have turned out to be a bad investment decision. Hence factoring multiple metrics is very important.

2 Valuation has to have some metrics or qualitative judgments that are forward-looking. Markets look to the future, and hence it is essential to have metrics that factor the future for a stock in terms of revenue/earnings growth potential. If forward looking numbers like consensus estimates are not easily available (since sometimes the subscription services for these are expensive), then at least a combination of trailing valuation metrics and qualitative judgement of forward-looking business prospects is essential.

3 Valuation can be absolute or relative or a combination of both. You can determine that a stock is a decent buy by valuing it on an absolute basis in terms of its current earnings, growth prospects and how much dividend it can pay, or/and you can value it based on how comparable companies are trading in the markets. However, this has to be founded in good discernment. Excessive or irrational valuation of a comparable company in the markets cannot be used to justify irrational valuation in another stock.

4 Valuation well done does not guarantee success. It only reduces the probability of mistakes and increases the probability of success. If the future and stock prices were clearly predictable, astrologers would be the richest people on earth. So, you could be absolutely right in the way you have valued a stock, but there are factors beyond you that will determine whether you make money in an investment or not.

Published on October 23, 2021

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