Is it inexpensive? Four different price metrics:

#Nothing is worth infinity. 

We can overpay for even the best of companies.

So even if we understand a business (first step) and find it to be good (second step) we can still make a bad investment by paying too much.

The third step in the value investing model asks a final fundamental question: Is it inexpensive?



Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)



#Price metrics

1.  Times free cash flow. 

It equals a company’s market capitalization divided by its levered free cash flow. It’s abbreviated
MCAP/FCF.

The denominator, levered free cash flow. 

• It’s cash flow from operations minus capex. 
• Note that it captures the payment of both interest and taxes.

The numerator, market capitalization, is often shortened to market cap.

• It’s the number of shares outstanding times the current price per share.

Notice the consistency between numerator and denominator.

• Market cap is the price for the equity only. 
• Levered free cash flow is the cash thrown off by the business after debtholders have been paid their interest.  Hence levered free cash flow goes to the equity holders.

Theoretically, market cap is what it would cost to buy all of a company’s outstanding shares.

• But it’s actually an underestimate. 
• That’s because the current share price reflects only what some shareholders were—moments ago—willing to take for their stock. 
• Most are holding out for more.

2.  Enterprise value to operating income. 
It’s abbreviated EV/OI.

The denominator, operating income. 

• It’s revenue, minus cost of goods sold, minus operating expenses. 
• Note that it’s not net of interest or tax expenses.

The numerator, enterprise value, is the theoretical takeover price.

• It’s what one would fork over to buy the entire company, not just the outstanding shares.
• Paying it would leave no one else with any financial claim on the company. 
• There’d be no outside common stockholders, no preferred shareholders, no minority partners in subsidiaries, no bondholders, no bank creditors, no one.

Enterprise value is a tricky concept, for two reasons.

1.  First, it’s derived in part from current market prices.

• So in name, it defies the value investing distinction between price and value. 
• The term enterprise price would make more sense.

2.  Second, it’s harder to calculate.

• In essence, it equals market cap plus the market price of all of the company’s preferred equity, noncontrolling interest, and debt and minus cash.

Like market cap, the enterprise value of a particular company is given on financial websites. Such off-the-shelf figures are convenient. But if a company looks promising, it’s wise to calculate enterprise value longhand. To see why, consider its components.



3.  Price to book. 
It equals market cap divided by book value. It’s abbreviated MCAP/BV.

Book value, recall, equals balance sheet equity.


4.  Price to tangible book value, or MCAP/TBV. 
It’s MCAP/BV with intangible assets removed from the denominator.   Patents, trademarks, goodwill, and other assets that aren’t physical get subtracted.

MCAP/TBV is a harsher measure than MCAP/BV.

• It effectively marks any asset that can’t be touched down to zero. 
• Some situations are better suited to this severity than others. 

To see which ones, we revisit goodwill.

Recall that goodwill equals acquisition price in excess of book value.

• We gave the example of company B having book value of $1,000,000; company A acquiring it for $1,500,000 in cash; and company A increasing the goodwill on its balance sheet by $500,000.

Note the assumption embedded in this practice.

• Goodwill is an asset. 
• So in buying company B and goodwill, company A is swapping assets for assets. That’s how accounting sees it. 
• No expense is recognized on the income statement, and no liability is booked on the balance sheet. 
• Nothing bad occurs.

#What’s inexpensive, and what isn’t?

1.  MCAP/FCF and EV/OI

When we calculate price metrics, we get actual numbers. MCAP/FCF may be 5, or 50. EV/OI may be 3, or 30. What’s inexpensive, and what isn’t?

I like MCAP/FCF to be no higher than 8, and EV/OI to be no higher than 7.  

Before moving on to benchmarks for the other two price metrics, let’s understand what these first two multiples mean.

• Imagine that a company’s future operating income will be $1,000,000 for each of the next 100 years. Discounting that stream back at—say—10 percent yields $9,999,274.
• That quantity, $9,999,274, is nearly $10 million. Notice that $10 million is 10 times the forecasted annual operating income.
• So if one calculates a company’s EV/OI as 10, that could mean that the market thinks operating earnings will be $1,000,000 for each of the next 100 years, and 10 percent is the right discount rate.
• Or, it could be mean that the market thinks operating income for the next 100 years will grow 4 percent annually from a $1,000,000 base, and that 14 percent is the right discount rate.

In other words, multiples are shorthand. 

• They’re shorthand for a formal present value analysis. 
• In them are embedded beliefs about growth rates and discount rates.

Holding everything else equal, it’s better to own a company with income that’s growing than one with income that isn’t. 

So when I say that I want EV/OI to be no higher than 7, what I’m saying is that I’ll only buy a stream of future operating income when it’s offered to me at a high discount rate.

Of course one never knows just what future operating earnings will be. Same with free cash flow. And where the exact discount rates come from isn’t important.

What is important is this: 
"low price multiples signal buying opportunities to the value investor when they reflect unjustifiably high discount rates."

2.  MCAP/BV and MCAP/TBV

The other two price metrics, MCAP/BV and MCAP/TBV, are a little different. 

• They don’t reflect a stream of future anything. 
• They’re multiples of what a company has now.

I prefer both MCAP/BV and MCAP/TBV to be no higher than 3.

But these are just qualifiers for me. They’re not what I look for.

What I look for is MCAP/FCF and EV/OI. 

It’s worth exploring why.


#Why MCAP/FCF and EV/OI are preferred to MCAP/BV and MCAP/TBV?

I aim to own companies that continue as going concerns.

• I want them alive. 
• Profitable ones are worth more that way. 

But MCAP/BV and MCAP/TBV express price relative to the value of companies dead. 

• If a firm stopped operating and sold everything—if it liquidated—the total amount available to distribute to shareholders would have something to do with its book value. 
• But when I buy a stock, I don’t hope for a stake in some dead company’s yard sale. I’m buying a claim on future streams of income and cash flow.

This isn’t to say that MCAP/BV and MCAP/TBV are useless. They can uncover opportunities. 

• Say that a company’s EV/OI is 9, and that both MCAP/BV and MCAP/TBV are 6. 
• The company doesn’t look inexpensive. 
• But MCAP/BV and MCAP/TBV are the same. 
• This leads the astute investor to see if the company owns some juicy tangible asset like land that’s carried on the balance sheet at a tiny, decades-old purchase price. 
• Will the company sell the land for cash? 
• Will that cash be excess? 
• If so, all of the price metrics could plunge. That’s the kind of useful thinking that the dead metrics tease out.

#The first step is to understand a business and the second step is to find it to be good; then valuation

Putting forth my benchmarks so bluntly—8, 7, 3, and 3—is a little dangerous and potentially misleading.

It’s dangerous because it could be interpreted to mean that it’s OK to cut right to valuation without first understanding a business and seeing if it’s good.  Many investors do that. And it can work. But with that approach mine are not the benchmarks to use.





Summary

Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)

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

Enterprise Value: Valuation of a company at its firm level

Think of enterprise value as the theoretical takeover price. 

In the event of a buyout, an acquirer would have to take on the company's debt but would pocket its cash.  EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value.  The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation. (Investopedia)



Enterprise Value of a Firm

EV of a Firm
= Market Capitalization + Debt + Minority Interest - Cash - Other Non-Operating Assets.


Minority Interest is the result of the consolidation of the subsidiary company's account and it doesn't belong to the common shareholders of the company.  The market value of MI is obtained by multiplying its book value by an appropriate price-to-book value.

The other non-operating assets such as investment in other companies, listed or non-listed, money market funds, investments in associates, etc.  are treated in a similar way as cash or cash equivalent as they can be sold without impacting its core business.


Debt and cash 

Debt and cash can have an enormous impact on a company's enterprise value. 

A)  EBIT MULTIPLE

Hence, when evaluating the fair price of a company or comparing companies, a better measure of value is the enterprise value divided by the EBIT or the operating income, instead of the too simplistic or flawed PE ratio.

EBIT Multiple = EV/EBIT


For an ordinary firm, an EBIT multiple of less than 8 may be considered as cheap.
For a high growth company, an EBIT multiple of 15 may be considered as fairly valued.

B)  EBITDA Multiple

For HIGHLY INDEBTED businesses, the EBITDA is often used by all capital providers to have an idea of the

• earnings available at their disposal for investments and interest payment, as well as 
• comparison among companies in the similar industry.  

This valuation metric resembles cash flows and is also useful for companies with temporary negative earnings.  

It is also a quick and dirty way for a Leverage Buy Out to value a target and to see how much leverage could slap on a company and still service the debt.

An EBITDA multiple of less than 11 for an ordinary company may be considered cheap.




Additional notes:

Valuation of a company at its firm level based on enterprise value.

Enterprise value looks at the value of the entire firm, for capitals both provided by equity shareholders and by the debt holders, and at the same time separating those assets not required or not used for the core operations of the business. 

It is important to understand enterprise value and use it for valuing an investment for potentially better outcome.

For a company

• without much cash and debt, and 
• without those non-operating one-time-off items, 

it may be adequate to just use the PE ratio to determine in relative term if the stock is worthwhile to invest in.


However, many companies have 

• substantial amount of cash or debts in their balance sheets, and 
• often with some extra-ordinary gain/loss or other one-time-off items, 

the use of the simplistic PE ratio would have missed the forest for the trees.

The simplistic PE ratio is useful as crude screening tool, but it has a serious limitation of ignoring the balance sheet items.  This can materially misrepresent the earnings yield of a business.


The EBITDA figure is not normally listed in the Income Statement, but we can add the depreciation and amortization figures in the cash flows statement to EBIT or operating income.

EBITDA = EBIT + Depreciation and Amortization

EBITDA Multiple = EV/EBITDA




Reference:

The Complete VALUE INVESTING Guide That Works by K C Chong
(Pages 246 - 251)

From Enterprise Value to Value per Share

Enterprise Value is the value of the entire company.


1.   It equals the sum of value of core operations plus value of nonoperating assets.

Enterprise Value or EV = Value of Core Operations + Value of Nonoperating assets


2.  Subtracting debt, debt equivalents, and hybrid securities, and making other adjustments, provides an estimate of the value of equity.

Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).


3.  The value of equity divided by undiluted shares outstanding gives value per share

Value per share = Value of equity / Undiluted shares outstanding




##############


Non-operating assets

The valuation must carefully evaluate the nonoperating assets, which consist of

• excess cash and marketable securities, 
• nonconsolidated subsidiaries and equity investments, 
• loans to other companies, 
• finance subsidiaries, 
• discontinued operations, 
• excess real estate, 
• tax loss carry forwards, and 
• excess pension assets.

Debts and debt equivalent

Debt and debt equivalents consist of

• debt of all kinds (for example, bonds, bank loans and commercial paper);
• operating leases; 
• securitized receivables; 
• unfunded pension liabilities; 
• contingent liabilities; and
• operating and nonoperating provisions.

Hybrid securities

Hybrid securities consist of

• convertible debt and 
• convertible preferred stock.  

ESOS and noncontrolling interest

Employee stock options and noncontrolling interests require additional adjustments.



############

Example:

A corporation has a 2 million shares outstanding.

Given the following information (all in millions), what is its value per share?

DCF of operations = $320m
Financial subsidiary value = $25m
Bonds = $185m
Discontinued operations = $2m
Securitized receivables = $4m
Operating leases = $6m


Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).



Financial subsidiary value & Discontinued operations = Nonoperating assets
Bonds, Securitized receivables & Operating leases = Debt and debt equivalent


Value of Equity
= ($320 )+ ($25 + $2) - ($185 + $4 + $6)
= $150m

Value per Share
= $150 m / 2m shares 
= $75 per share.

Calculating Intrinsic Value

Free Cash Flow of Firm

FCFF = CFO - Capex
Enterprise Value = FCFF / WACC
Enterprise Value = Equity Value + Net Debt
Equity Value = Enterprise Value - Net Debt


Free Cash Flow of Equity

FCFE = CFO - Capex + Net Debt
Equity Value = FCFE / Required rate of return on equity


Equity Value = Intrinsic Value


Investors compare this Equity Value to the Market Value in their investing.

Market Value > Equity Value = Overvalued
Market Value = Equity Value = Fair Value
Market Value < Equity Value = Undervalued



Additional Notes:

Assuming there is no preferred stock outstanding:

Interest*(1–t) is the firm's after-tax interest expense

If company has zero debt, its FCFF = FCFE

Using Free Cash Flow to Equity to derive the Equity or Intrinsic Value of a Stock

Free cash flow to equity

From Wikipedia, the free encyclopedia

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders.^[1][2] The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

Contents

  [hide] 

• 1Basic formulae
• 2FCFF vs. FCFE
• 3Negative FCFE
• 4Use
• 5References
• 6External links

Basic formulae[edit]

Assuming there is no preferred stock outstanding:

${\displaystyle FCFE=FCFF+Net\ Borrowing-Interest*(1-t)}$

where:

• FCFF is the free cash flow to firm;
• Net Borrowing is the difference between debt principals paid and raised;
• Interest*(1–t) is the firm's after-tax interest expense.^[3]

or

${\displaystyle FCFE=NI+D\&A-Capex-\Delta WC+Net\ Borrowing}$

where:

• NI is the firm's net income;
• D&A is the depreciation and amortisation;
• Capex is the capital expenditure;
• ΔWC is the change in working capital;
• Net Borrowing is the difference between debt principals paid and raised;
• In this case, it is important not to include interest expense, as this is already figured into net income.^[4]

FCFF vs. FCFE[edit]

• Free cash flow to firm (FCFF) is the cash flow available to all the firm’s providers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to support the firm’s productive capacity. The providers of capital include common stockholders, bondholders, preferred stockholders, and other claimholders.
• Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders only.
• If the firm is all-equity financed, its FCFF is equal to FCFE.

Negative FCFE[edit]

Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately. Some examples include:

• Large negative net income may result in the negative FCFE;
• Reinvestment needs, such as large capex, may overwhelm net income, which is often the case for growth companies, especially early in the life cycle.
• Large debt repayments coming due that have to be funded with equity cash flows can cause negative FCFE; highly levered firms that are trying to bring their debt ratios down can go through years of negative FCFE.
• The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the FCFE to be negative in the big reinvestment years and positive in others;^[5]
• FCFF is a preferred metric for valuation when FCFE is negative or when the firm's capital structure is unstable.

Use[edit]

There are two ways to estimate the equity value using free cash flows:

• Discounting free cash flows to firm (FCFF) at the weighted average cost of capital (WACC) yields the enterprise value. The firm’s net debt and the value of other claims are then subtracted from EV to calculate the equity value.

Enterprise Value EV = FCFF/WACC

Enterprise Value EV = Equity Value + net Debt

Equity Value = Enterprise Value EV - net Debt

• If only the free cash flows to equity (FCFE) are discounted, then the relevant discount rate should be the required return on equity. This provides a more direct way of estimating equity value.

Equity Value = FCFE/required return on equity

• In theory, both approaches should yield the same equity value if the inputs are consistent.

Notes:

Equity Value = Intrinsic Value of the Company

FCFF / WACC = Enterprise Value
Enterprise Value = Equity Value + Net Debts
Equity Value = Intrinsic Value of the stock = Enterprise Value - Net Debts

FCFE = CFO - Capex + Net Debts
Equity Value = Intrinsic Value of the stock = FCFE/required rate of return on equity
Equity Value < Market Value = Overvalued

Equity Value = Market Value = Fair Value
Equity Value > Market Value = Undervalued

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

Enterprise Value Multiples

Enterprise value (EV) is calculated as the market value of the company's common stock plus the market value of outstanding preferred stock if any, plus the market value of debt, less cash and short term investment (cash equivalent).

EV
= market value of company's common stock
+ market value of outstanding preferred stock
+ market value of debt
- cash and short term investment (cash equivalent)

It can be thought of as the cost of taking over a company.



EV/EBITDA multiple

The most widely used EV multiple is the EV/EBITDA multiple.

EBITDA measures a company's income before payments to any providers of capital are made.

The EV/EBITDA multiple is often used when comparing two companies with different capital structures.


Loss-making companies usually have a positive EBITDA

Loss-making companies usually have a positive EBITDA, which allow analysts to use the EV/EBITDA multiple to value them.  

The P/E ratio is meaningless (negative) for a loss making company as its earnings are negative.

Enterprise Value and Acquirer’s Multiple. Using Total Enterprise Value / EBIT as the primary tool to evaluate and compare the earnings power of a company.

Investors should make the ratio of a company’s TEV/EBIT a primary tool to evaluate its earnings power and to compare it to other companies instead of PE ratio.

Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.



Enterprise Value

Total Enterprise Value

The simplistic PE ratio is useful as crude screening tool but it has a serious limitation of ignoring the balance sheet items. This can materially misrepresent the earnings yield of a business.

One way to look at it is considering the total enterprise value (TEV) of two companies, A and B and see which one is cheaper to buy the whole business as explained in Investopedia as below:

[Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus TEV provides a much more accurate takeover valuation because it includes debt in its value calculation.]

TEV = Market Capitalization + Debt + Minority Interest - Cash – other non-operating assets

• The market capitalization is the market value of the common shareholders’ equity equals to number of shares multiply by share price.
• The debts is the market value of interest bearing bank loans, bonds, commercial papers etc. In financial solid businesses the market value of debt corresponds to its book value.
• Minority interest is the result of the consolidation of the subsidiary company’s account and it doesn’t belong to the common shareholders of the company. The market value of MI is obtained by multiplying its book value by an appropriate price-to-book value.
• Cash and cash equivalents are deducted from the enterprise value as they lower the purchase price. They can be distributed or used for the reduction of debts in an acquisition.
• The other non-operating assets are treated in a similar way, as they can be sold without impacting the cash flow situation, for example properties, investments in associates etc.

Acquirer’s Multiple (TEV/Ebit)

So why is the Acquirer’s Multiple so important? For a couple of reasons. First, it allows us to see how cheap a stock currently is. Unlike a discounted cash flow analysis, calculating a stock’s current TEV/Ebit requires no estimates into the future.

Secondly, I often use TEV/Ebit as my main valuation tool to compare the relative price-value relationship of companies in the same industry to see which one is a better buy.

For individual cases, I will be happy to invest in a company with normal growth rate of say 8% with TEV/Ebit < 7, following Warren Buffett's metric.  Flip it over, we get an earnings yield for the enterprise of 14%, or an after tax earnings yield of 11%., which I am satisfied of.

Conclusions

Investors should make the ratio of a company’s TEV/EBIT a primary tool to evaluate its earnings power and to compare it to other companies instead of PE ratio. This is the ratio that Joel Greenblatt uses for his Magic Formula by flipping it over and that Buffett uses when evaluating a business. Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.

Balance sheet is also a very important part of our analysis, not only to avoid liquidity and bankruptcy risks in times of economic downturn and financial crisis, but also for a price Vs value investing decision.

Reference:

Enterprise Value and Acquirer’s Multiple kcchongnz

http://klse.i3investor.com/blogs/kcchongnz/84689.jsp

Investing and The Eighth Wonder of the World kcchongnz

http://klse.i3investor.com/blogs/kcchongnz/92412.jsp

Quick and Steady return

Figure 1 below shows the typical 10-year return of a “Quick” speculator and a “Steady” long-term investor, both starting with RM100000.

Quick aims for fast gain, getting in and out of the market, buys and sells based on what the charts tell him to, and always looking for “the next big thing”. It has a higher average return over the 10 years of 15% a year, higher than the average, and more steady return of the long-term investor, Steady, of 10%. Table 1 in the Appendix shows the hypothetical annual return of both the market players.

At the end of 10 years, Figure 1 shows that the RM100000 invested by Steady has accumulated to RM253000, 37% more than what Quick has accumulated in the amount of only RM106000. The compounded annual rate (CAR) of Steady is 9.7%, whereas Quick could only achieve a CAR of just 0.6%, although it has a much higher average return.

Who is better here; the rabbit of the turtle? A sprinter of a marathon runner in a 10km race?

Appendix

Table 2: 10-year return of some stocks in Bursa

Table 3: 10-year Return of lemons