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

What is EBITDA?

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Although it sounds intimidating upon first glance, it is nowhere near as complicated as it looks. Essentially, it is a good indicator of a company's financial performance.

How do you calculate EBITDA?

EBITDA is calculated as shown by the formula below:

EBITDA = Revenues - Expenses

The expenses obviously do not include interest, taxes, depreciation, and amortization.

What is the significance of EBITDA?

EBITDA is used to analyze and compare profitability between industries and companies. One of its most important traits is that it eliminates the effects of accounting and financing decisions, which can greatly skew a company's earnings from quarter to quarter. However, this does allow the company more leeway in choosing the data to use in this calculation.

Watch out for...

EBITDA is commonly quoted by many companies, especially in the tech sector, to hide something in their finances. The companies have discretion as to what goes in EBITDA, so make sure to look at other metrics to make sure that the company you are researching really is a solid buy.

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

Earnings before interest and taxes (EBIT)

In accounting and finance, earnings before interest and taxes (EBIT) or operating income is a measure of a firm's profitability that excludes interest and income tax expenses.


EBIT = Operating Revenue – Operating Expenses (OPEX) + Non-operating Income

Operating Income = Operating Revenue – Operating Expenses

Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income.

A professional investor contemplating a change to the capital structure of a firm (e.g., through a leveraged buyout) first evaluates a firm's fundamental earnings potential (reflected by Earnings Before Interest, Taxes, Depreciation and Amortization EBITDA and EBIT), and then determines the optimal use of debt vs. equity.

To calculate EBIT, expenses (e.g., the cost of goods sold, selling and administrative expenses) are subtracted from revenues.^[3] Profit is later obtained by subtracting interest and taxes from the result.

Statement of Income — Example (figures in millions)
Operating Revenue
Sales Revenue	$20,438
Operating Expenses
Cost of goods sold	$7,943
Selling, general and administrative expenses	$8,172
Depreciation and amortization	$960
Other expenses	$138
Total operating expenses	$17,213
Operating income	$3,225
Non-operating income	$130
Earnings before Interest and Taxes (EBIT)	$3,355
Net interest expense/income	$145
Earnings before income taxes	$3,210
Income taxes	$1,027
Net Income	$2,183

(Table info source: Bodie, Z., Kane, A. and Marcus, A. J. Essentials of Investments, McGraw Hill Irwin, 2004, p. 452.)

http://en.wikipedia.org/wiki/Earnings_before_interest_and_taxes

Income Statement Format with EBIT and EBITDA

How Parts of the Financial Statements Fit Together

A Summary of Accounting Relations

The Balance Sheet

Assets
- Liabilities
=Shareholders' equity


The Income Statement

Net revenue
- Cost of goods sold
= Gross margin
- Operating expenses
= Operating income before interest and taxes (ebit)
- Interest expense
= Income before taxes
-  Income taxes
= Income after tax and before ordinary items
+ Extraordinary items
= Net income
- Preferred dividends
= Net income available to common


Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash flow from operations
+ Cash flow from investing
+ Cash flow from financing
= Change in cash


Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement)

Beginning equity
+ Comprehensive income
- Net payout
= Ending equity

Net Income
+ Other comprehensive income
= Comprehensive income

Dividend
+ Share repurchases
= Total payout
- Share issues
= Net payout