Earnings Yield of the Enterprise

EBIT multiple  = EV / EBIT

Earnings Yield of the Enterprise (before tax)  EY = EBIT / EV

For example:
EY of A = 11.3%
EY of B = 15.3%

The EY of B at 15.3% is higher than the 11.3% of A, hence, B is a cheaper buy than A.

The EY computation is pre-tax EY and this is good enough for comparison among companies.  

For determining if you would like to invest in a stock, use after-tax EY so that you can compare with other alternative investments.


EY (after tax) = (EBIT x (1 - tax rate) / EV

For example:
EY (after tax) of A = 8.5%
EY (after tax) of B = 11.5%



Why is the earnings yield so important?

1.  It allows you to see how cheap a stock currently is.  Unlike a DCF analysis, calculating a stock's current earnings yield requires no estimates into the future.

2.  Using earnings yield as your main valuation tool to compare the relative price-value relationship of companies in the same industry, helps you to see which one is a better buy.. For individual cases, the investor should be happy to invest in a company with normal growth rate of 5% with an after-tax earnings yield of 12%.



How to use EV / EBIT?

1)  EV / EBIT as a primary tool to

• evaluate its earnings power and
• to compare it to other companies, 

in addition to the PE ratio.


2)  Joel Greenblatt uses for his Magic Formula the Earnings Yield of the enterprise, in conjunction with the Return on Invested Capital (ROIC).

3)  Buffett uses this when evaluating a business and has said that he will generally be willing to pay 7 x EV / EBIT for a good business that is growing 8% - 10% per year


4)  For cyclical plantation companies which have a lot of debts, it is more appropriate to use EBIT multiple and EV per hectare, rather than basing on PE ratio and market cap per hectare.


Summary

EBIT multiples (EV / EBIT) are better market valuation metrics than PE. 

However, both EBIT multiples and PE are all relative and comparative metrics.. 

It would be better if we can determine the absolute value of a stock, the intrinsic value. 

We can then compare the market price with the intrinsic value and determine the margin of safety to give us a better decision making in stock investment.



Reference::

Pages 251 - 252
The Complete VALUE INVESTING Guide that Works!  by K C Chong

Which company is cheaper? (Understanding P/E, Earnings yield and EBIT/EV.)

Consider two companies, Company A and Company B.

They are actually the same company (i.e. the same sales, the same operating earnings, the same everything) except that Company A has no debt and Company B has $50 in debt (at a 10% interest rate).

All information is per share

Company A

Sales                     $100
EBIT                         10
Interest expense          0
Pretax Income           10
Taxes @ 40%             4
Net Income               $6


Company B

Sales                     $100
EBIT                         10
Interest expense           5
Pretax Income             5
Taxes @ 40%             2
Net Income               $3


The price of Company A is $60 per share.
The price of Company B is $10 per share.

Which is cheaper?

P/E of Company A is 10 ($60/6 = 10).  The E/P or earnings yield, of Company A is 10% (6/60).
P/E of Company B is 3.33 ($10/3 = 3.33). The E/P or earnings yield of Company B is 30% (3/10).

So which is cheaper?
Using P/E and earnings yield, Company B looks much cheaper than Company A.

So, is Company B clearly cheaper?


Let's look at EBIT/EV for both companies.

Company A
Enterprise value (Market price + debt)   60 + 0 = $60
EBIT   $10


Company B
Enterprise value (Market price + debt)   10 + 50 = $60
EBIT   $10

They are the same! Their EBIT/EV are the same.

To the buyer of the whole company, would it matter whether you paid $10 per share for the company and owed another $50 per share or you paid $60 and owed nothing?

It is the same thing!

*You would be buying $10 worth of EBIT for $60, either way!




Additional note:

* For example, whether you pay $200k for a building and assume a $800k mortgage or pay $1 million up front, it should be the same to you.  The building costs $1 million either way!

[Using EBIT/EV as your earnings yield provide a better picture than E/P, of how cheap or expensive the asset is.]

Pretax operating earnings or EBIT (earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using EBIT allowed us to view and compare the operating earnings of different companies without the distortions arising from the differences in tax rates and debt levels.  For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed) and to the price you are paying.

Returns on Capital
= EBIT / (Net Working Capital + Net Fixed Assets)

Earnings Yield
= EBIT / EV
= EBIT / Enterprise Value

As an investor, you are looking for companies with high Returns on Capital and selling for a bargain or high Earnings Yield (EBIT / EV).

REF:  The Little Book that still Beats the Market by Joel Greenblatt