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

Using Multiples

The use of multiples can increase valuations based on DCF analysis.

There are five requirements for making useful analyses of comparable multiples:

1. value multibusiness companies as a sum of their parts,
2. use forward estimates of earnings,
3. use the right multiple,
4. adjust the multiple for nonoperating items, and,
5. use the right peer group.

1.  Value Multibusinesses companies as a sum of their parts

Multibusiness companies' various lines of business typically have very different growth and ROIC expectations.

These firms should be valued as a sum of their parts.



2,  All Multples should use forward estimates of earnings

All multiples should be forward-looking rather than based on historical data, as valuation of firms is based on expectations of future cash flow generation.


3.  Use the Right Multiples

(a) Value-to-EBITA & P/E Multiples

The right multiple is often the value-to-EBITA ratio.

This measure is superior to the price-to-earnings (P/E) ratio because:

• capital structure affects P/E and 
• nonoperating gains and losses affect earnings.

(b) Alternative Multiples

Alternatives to the value-to-EBITA and P/E multiples include

• the value-to-EBIT ratio, 
• the value-to-EBITDA ratio, 
• the value-to-revenue ratio, 
• the price-to-earnings-growth (PEG) ratio, 
• multiples of invested capital, and 
• multiples of operating metrics.

4.  Adjust the multiples for nonoperating items

All of these ratios should be adjusted for the effects of nonoperating items.



5.  Use the right Peer Group

The peer group is important.

The peer group should consist of companies whose underlying characteristics (such as production methodology, distribution channels, and R&D) lead to similar growth and ROIC characteristics.

Enterprise Multiple = EV / EBITDA

What It Is:

Enterprise multiple is a financial indicator used to determine the value of a company. It is equal to a company’s enterprise value divided by its EBITDA (Earnings Before Interest, Taxes, Depreciation andAmortization).

How It Works/Example:

The enterprise multiple has many uses. In addition to helping investors determine if a company is over- or undervalued, it is also used by analysts to examine companies during the due diligence process that precedes a potential acquisition.

To determine the enterprise multiple, you much first find the company's enterprise value (market capitalization + value of debt, minority interest, and preferred shares - value of cash and cash equivalents). Once you know the company's EV, simply divide by the company's EBITDA.

Enterprise Multiple = EV/EBITDA

A company with a low enterprise multiple is considered to be an attractive takeover candidate (and investment), because it reflects a low price for the value of the company (more company for your dollar).  Enterprise multiples are compared to other companies within the same industry and not across industries in order to obtain an insightful assessment.

Why It Matters:

The enterprise multiple ratio is considered a more accurate barometer of the firm's value than the price-to-earnings (P/E) ratio since it discounts various countries taxing policies and takes into account debt and cash on hand. The enterprise multiple provides a more accurate insight into the company as it provides the acquirer with better information about the company's prospects and will prevent the acquirer from overpaying as well as avoid a potentially inferior acquisition.

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/enterprise-multiple-625

Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based:  The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based.  The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money.  The DCF method has many advantages, the most important being its future-looking orientation.  This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.

Finance for Managers - Earnings-Based Valuation - EBIT Multiple

The reliability of the multiple approach to valuation we have just described depends on the comparability of the firm and firms used as proxies for the company whose value we seek to estimate.  In the preceding Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated's.  Unfortunately, these two companies could produce equal operating results yet indicate much different bottom-line profits to their shareholders.  How is this possible?  The answer is twofold:  the manner in which they are financed, and taxes.  If a company is heavily financed with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line.  Likewise, one company's tax bill might be much higher than the other's for some reason that has little to do with its future wealth-producing capabilities.  And taxes reduce bottom-line earnings.

Consider the hypothetical scenario in table 10-a.  Notice that the two companies produce the same earnings before interest and taxes (EBIT).  But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000).  This dramatically reduces its earnings before income taxes relative to Amalgamated.  Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.

This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company.  The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process.  Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization.   Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms.  By using EBITDA in the valuation equation, this potential distortion is avoided.

Table 10-a

Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation

                                                         Amalgamated     Acme
Earnings before Interest and Taxes      $757,500        $757,500
Less:  Interest Expenses                      $110,000        $350,000
  Earnings before Income Tax              $647,500        $407,500
Less:  Income Tax                               $300,000       $187,000
  Net Income                                       $347,500       $220,500

Basic financial statements (Profit and Loss Account)

The particulars of a regular company's Profit & Loss Account would look as follows:

Revenue - Sales value generated
Cost of Goods Sold - All costs related to the sale of the goods
Gross Profit - The excess of revenue over cost of goods sold (or likewise Gross Loss if otherwise)
Operating Expenses - All remaining expenses of the operations
EBITDA - Earnings before interest, taxes, depreciation & Amortisation
Depreciation - The decrease in the value of capital assets which are expensed off
EBIT - Earnings before interest and taxes
Interest - Interest cost of borrowings
Taxes - Taxes imposed on income
Net Profit - The final bottom line



Saturday December 11, 2010

Basic financial statements interpreted

By RAYMOND ROY TIRUCHELVAM


FOR a non-finance person, evaluating a company's financial can be daunting, let alone understanding it to form an opinion. The most basic form of financial statements comprises the Profit & Loss Account or sometimes referred to as Income Statement and the Balance Sheet.

Another two statements that make a complete financial information for reporting purposes comprise the Statement of Retained Earnings and Statement of Cash Flow.

The objective of a financial statement is to provide information about the financial position, performance and changes in the position of an enterprise.

The Balance Sheet represents the financial position or net worth of a business entity on a specified date. The presentation is based on a fundamental accounting equation of Assets = Liabilities + Shareholders Fund. The main categories of assets are usually listed first, usually in order of liquidity. Next follows liabilities, short and long term, which represent payables and borrowings held by the entity.

The difference between the assets and liabilities (Assets Liabilities = Shareholders Funds), is known as Shareholders Funds, or sometimes referred to as owner's equity, that entails the company's capital plus retained earnings. Borrowings (liability) or owner's money (owner's equity) are the two means used for financing an asset.

Mathematically, over a period of time, if the assets grow bigger than the liabilities, it would mean that the entity has made a profit (which represents the essence of the Profit & Loss Account); this is reflected via an increased asset base (taking shape in many forms from cash, inventories, accounts receivable, fixed assets or investments).

Reverting to the Balance Sheet equation, the Shareholders Fund will reflect the increment. Since the entity's capital remains constant (unless the new assets are caused by new share issues), the increment is credited to a special account called Retained Earnings, as the name denotes.

Next, the Profit & Loss Account represents summarised transactions of an entity's performance over a given period, showing its profitability (or losses). Acting as the management's scorecard, it identifies the revenues and expenses undertaken which results in either a profit or a loss, based on the fundamental accounting concept of: Revenue Expenses = Profit (or Loss if expenses exceed revenue).

This in return will drive the direction of the Shareholders Fund (in particular Retained Earnings sub-category), for good (profit) or for worse (loss).

The particulars of a regular company's Profit & Loss Account would look as in Table 1.

There is also a category of item to be on the lookout called Unusual Item, which represents non-recurring non-revenue based transaction undertaken by the entity that results in a profit or loss. Examples of MAS selling aircraft, discontinuing a business line, incurring losses from natural disaster, writing down of investment value, are a few, which should be evaluated separately from the results from operations.

Due to its importance, EPS or Earnings Per Share is also required to be disclosed at the end of the Profit & Loss account. It presents the earnings divided by the total ordinary shares outstanding.

This single measure differentiates the efficiency in the earnings between companies, and represents the most important criteria in determining the price of the entity's shares and is used as a component to derive the all important PE or Price to Earnings ratio.

A large Retained Earnings balance as compared to the total Shareholders Fund, will denote a profitable company (accumulation of profits over the years), and a negative Retained Earnings (or Retained Loss) reflects the opposite. In extreme cases, the Retained Loss (debit balance) can overtake the Share Capital (credit balance), thus resulting in a negative Shareholders Fund. One surely would not want to invest in such a company.

Some listed companies, when the Retained Earnings gets so large (coupled with other factors such as inability to pay out dividend), reward the shareholders via Bonus Issue exercise, whereby part of the retained earnings are converted into new shares, accruing to existing shareholders.

This not only represents a short cut of the dividend payout, but also a tax free option via capital returns.

Raymond Roy Tiruchelvam, who has problems reconciling his gross habits with his net income is a financial planner with SABIC Group of Companies.

http://biz.thestar.com.my/news/story.asp?file=/2010/12/11/business/7567075&sec=business

Valuing a Business (Power Point Presentation)

Earnings Multiple (Value-to-Earnings) Ratio: 
A ratio is determined by dividing the firm’s value by its earnings that can be compared to representative ratios of recently-sold similar firms.

Normalized Earnings:  Earnings that have been adjusted for unusual items, such as fire damage, and all relevant expenses, such as a fair salary for the owner’s time

Type of Firm ####Earnings Multiple
 
Small, well-established firms, vulnerable to recession ####7



Small firms requiring average executive ability but operating in a highly competitive environment ####4


Firms that depend on the special, often unusual, skill of one individual or a small group of managers#### 2

 
 
Risk and Growth in Determining a Firm’s Value:


Risk and Growth are Key Factors Affecting the Earnings Multiple and Firm Value


The more (less) risky the business, the lower (higher) the appropriate earnings multiple and, as a consequence, the lower (higher) the firm’s value.

The higher (lower) the projected growth rate in future earnings, the higher (lower) the appropriate earnings multiple and, therefore, the higher (lower) the firm’s value.


 
Cash Flow-Based Valuation


Determination of the value of a business by estimating the amount and timing of its future cash flows

Step 1. Project the firm’s expected future cash flows.

Step 2. Estimate the investors’ and owners’ required rate of return on their investment in the business.

Step 3. Using the required rate of return as the discount rate, calculate the present value of the firm’s expected future cash flows, which equals the value of the firm.

 
http://www.andrews.edu/~schwab/sbm-appb.ppt#8

****How much is your business worth?

How much is your business worth?
If you are thinking of selling up, what could you get for your business?


General Principals
The largest influence on the price you will get for your business is the Law of Supply & Demand. If, when you sell, there are plenty of buyers with ready cash and few sellers, you will get a good price. If the converse is true, you will either not get a good price or, even worse, you may find you cannot sell up.

Generally, people do not buy a business for what it is; they will buy for what the business does for them. Namely earn them cash to repay their investment, provide them with a living, and build for the future. With cash (not profits) uppermost in their mind on the first two of these, the price is often based on something called 'EBITDA'. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is an accountancy term that represents the sustainable cash profits of the business assuming nil borrowing costs.

To value the business, a multiple is applied to EBITDA. The Law of Supply & Demand essentially dictates the multiple for a particular business sector, or any part of it, or any particular firm. There is no universally agreed multiple for a particular sector, or firm, and multiples vary widely between and within particular sectors depending on a number of factors, but principally the certainty and size of the future cash flows of the business. The multiple applied to your business will depend on a combination of factors, we go into some of these factors in detail below.

Pricing a business is thus more of an art than a precise science. It is not merely a calculation based on two predetermined numbers, and valuers, purchasers and vendors often arrive at differing figures. At the end of the day it is you who has to be satisfied that you have got the best deal under the circumstances.

To get the best price, the main issue you should concentrate on is timing. When the business is ripe for sale, it is often not the right time for you personally or there are too few purchasers with ready cash. All other permutations apply, except the one where all the circumstances fit together neatly. Consequently selling your business generally involves some form of compromise. This makes the decision more difficult for you, especially if you are emotionally tied to the business. There is always a lot going on in the business when you sell, negotiations are intense, and feelings high: selling is a stressful time for you. So it is important that you plan in advance how you are going to sell the business. Only by doing so will you maximise the price you will get. When planning, you should bear in mind the following:

Size
Forget the old maxim, size is important. Large firms attract bigger multiples and more interest than smaller firms because they are perceived as being less risky. Larger firms are less likely to fail and are less reliant on the owner's involvement. Your firm, however large it grows in its niche or how profitable it becomes, may be too small to attract the right purchaser, namely the one with cash. Thus ignore the price achieved for one of your larger, more inefficient, competitors: you may never achieve a similar multiple however good your business is.


Growth
Growth prospects are one of the more major factors affecting the multiple. Buyers will pay more for businesses with higher growth rates as they repay their initial investment quicker than those with low or no growth. Consider selling up before turnover or profits have levelled out. This may go against the grain where you have put in place the basis for such growth, but increasing the multiple, as opposed to increasing the EBITDA, will have a bigger impact on the price you achieve.

Profitability
High gross margins and good levels of cash generation from profits give buyers more flexibility going forward and reduce the risk of the investment proving bad. Buyers will pay more for businesses that consistently report better than industry average figures.

However, the fact that you operate an extremely tight ship may put a buyer off paying too high a price. Buyers will look for easy wins/cost savings, so if a buyer identifies areas where he can make large efficiency savings or growth that could make your company more valuable to him. It is often worthwhile specifically targeting potential purchasers able to achieve such synergies.

Sector
Some sectors attract better multiples than others. There are a number of reasons for this: fashion (such as the dot-coms, energy businesses etc); estimates as to future growth prospects; robustness at times of boom and bust etc. In general, the more certain the future cash flows of a sector, or company, the higher the multiple.

However, some niches within a sector can command a premium from time to time, depending on the then demand for the particular product/service. Building a 'sustainable competitive advantage' and 'Unique Selling Point(s)' in a small niche can produce a handsome price at a time of boom in that sector generally and a better than average price when times are bad.

Business Mix
Diversification, although often reducing operating risk, does not always add to value: it can reduce the value of the overall business. Buyers may only be willing to take on that part of your business that fits in well with theirs; they could either discount the overall price, leave you with the part they do not want or, in the worst case, you could find your business un-saleable. It may be safer to stay in a particular part of the sector, especially for smaller businesses, as it can be difficult to find a buyer who will appreciate diversity.

Customer Base
The quality of your customer base is one of the main factors influencing the multiple used. Customer bases made up of blue chip clients in growing industries attract higher multiples, particularly if there are opportunities for the buyer to sell additional services in to them. If specific customers, or customers in a particular industry, make up a large part of your business, it will affect your pricing, because buyers will see you as having too many eggs in one basket.

Other Factors
Another important component is the strength of the balance sheet. Once buyers have bought a business, they want to focus on growing it and integrating it into their own organisation, rather than deal with historic balance sheet problems.

Buyers will assess the former owner's management of working capital. Businesses with a history of good cash, debtor, and creditor management attract higher multiples than those with a poor track record.

Other balance sheet factors that can influence a firm's value such as the amount of bank / factor debt, and any impending litigation.

The Deal
It is important to many buyers to retain the owner, at least for a period of time, to help introduce them to customers and make sure staff are comfortable with the new regime.

Often a buyer will agree to pay an incentive (this is termed an 'earnout') to the owner to encourage him to stay and to seek to avoid bearing the entire risk of the acquisition. Buyers often look to pay the former owner a share of profits earned over a two or three year period.

Earnouts can constitute a major part of the purchase price. The smaller the company, the more uncertainties there are that could affect how the business might perform, and thus the more likely it is that the buyer will seek an earnout. With planning an exit taking up to two/three years, and the earnout a similar period, it could be five years before you can book your sun lounger fulltime.

Earnouts is one area where your advisers really earn their money. Earnouts create conflicting interests between the current and former owners of the business; there is a risk that the buyer will look to reduce or defer profits in order to minimise the earnout paid. The former owner will look to maximise profits and hasten their recognition. With the former owner having little or no influence post sale over strategy, accounting policies, expenditure etc, there is a very real risk that he could receive less than originally envisaged for the business. It is important that your advisers protect your position wherever possible.

There is a balancing act to be struck, you will have to decide how much money you are willing to wait for and form your own view of the risks involved based on the likely future profitability of the business and your assessment of the purchaser, as against accepting a lesser, but more certain, sum now.

Today's Market
At the end of the day, any business is only worth what you can get for it at the time you sell it. A mathematical calculation of value is a mere indication of potential worth, a discussion tool to be used during the negotiation process. Confidence levels set the level of demand for your business, and in turn how much purchasers may be willing to pay for it. Whilst any downturn will ultimately effect multiples, to get maximum value and increase the certainty of a sale, it is more important than ever that owners considering selling prepare and position their business ready for sale early, and that during the sale process is carried out in such a way as to target purchasers with the right fit, hunger and cash to complete a deal.


http://www.startinbusiness.co.uk/features/features/29_01_2003_biz_valuation.htm

Enterprise Value

Enterprise Value

Enterprise value (EV) is a company’s market capitalization plus net interest-bearing debt.


In other words, it is the amount of cash required to buy the company at its current price and retire all interest-bearing debt less the cash assets of the business.

EV = Market Capitalization + Net interest-bearing Debt

or

EV = Market Capitalization + Borrowings - Cash


Although used for various reasons by stock analysts, the only useful purpose for calculating EV is as a tool to determine the maximum price a company is prepared to pay to acquire another business.


For instance, one company had a policy of limiting the EV it was prepared to pay to an EBIT multiple of 5. So if EBIT was $20 million, EV should be no more than $100 million. If interest-bearing debt happened to be $50 million, then $50 million would be the maximum price it would pay for the equity of the business.


EV = Market Capitalization + Borrowings - Cash
$100m = Market Capitalization + $50m - $0
Market Capitalization = $100 m - $50 m + $0 = $50 m



-----

Let’s see the ROE on the acquisition cost of $50 million.


Acquisition cost = $50 million. Calculate ROE


EBIT = $20 m
Interest-bearing debt = $50 m
Interest cost of 8 percent on the debt
Corporate tax rate = 30 percent


Interest cost = $50 m x 8 percent = $4 m


Post-tax profit = EBIT x (100 percent – Corporate tax rate) = [($20 m - $4 m) x (70 percent)] = $11.2 m


ROE = ($11.2 m/ $50 m) = 22.4 percent on an equity cost of $50 million.

-----



If the company to be acquired had no debt and
acqusition cost was $50 million:



Interest-bearing debt = $ 0
Post-tax profit = EBIT x 70 percent = $20 million x 70 percent = $14 million
Return on cost of $100 million would be 14 percent.


The acquired company would then be geared up by borrowing $50 million.
Interest cost = $50 m x 8 percent = $4 m


Post-tax profit = EBIT x (100 percent – Corporate tax rate) = (20m – 4m) x (70 percent) = $11.2 m


ROE = $11.2m / $50m = 22.4 percent return on the net $50 million acquisition cost.

-----



EBIT multiple and ROE


From the examples above:

EV = EBIT x EBIT multiple
EBIT multiple = EV/EBIT

EBIT multiple of 5 produces a ROE of 22.4 percent.


Determine the EBIT multiple beyond which debt of 8 percent would produce a return (ROE) of less than 8 percent.
Answer: 1 / (8 percent) = 12.5


Therefore,

Paying an EBIT multiple MORE THAN 12.5, produces Return on Equity (ROE) LESS THAN the interest cost of debt of 8 percent.

Paying an EBIT multiple LESS THAN 12.5, produces Return on Equity (ROE) MORE THAN the interest cost of debt of 8 percent.

-----

Also read:

http://www.horizon.my/2008/12/malaysian-airlines-is-mas-cheaper-than-air-asia/
Malaysian Airlines – Is MAS Cheaper than Air Asia?