What Is The Best Valuation Metric For A Stock: P/E Ratio, EV/EBITDA Ratio, Or Price To Free Cash Flow Ratio?
The P/E ratio is quick and easy but can be inaccurate due to non cash accounting items. The price to free cash flow ratio only counts cash flow items but working capital fluctuations make it less useful. The EV/EBITDA ratio is the most comprehensive but does exclude some costs. There seems to be about as many different valuation metrics for stocks as there are stocks. You have price to sales, price to book, price to earnings, free cash flow yield, EBITDA multiples, dividend yield, and more. So which one is the best to use? In this article we’ll take a look at three of the most popular and widely used metrics: P/E, Price to Free Cash Flow (or Free Cash Flow Yield), and the EV/EBITDA ratio to uncover some hidden flaws o some of the metrics and find out which one is the best to use. P/E Ratio The P/E or Price to Earnings ratio is one of the most popular and easiest ways of valuing a stock. Unfortunately it’s also one of the most flawed ways to value stocks because of numerous accounting items that can drastically change a companies reported earnings. Let’s take a look at a few examples of some common occurrences that render the P/E ratio useless for valuing companies. For our first example we will look at the case of Lockheed Martin (NYSE: LMT ). Like all defense contractors Lockheed Martin is reimbursed by the US government for all pension costs associated with government contracts. Since over 80% of Lockheed Martin’s revenue comes from the government most of Lockheed’s pension costs will be reimbursed by the US government. As a public company Lockheed must account for pension liabilities and fund its pension plan according to Financial Accounting Standards (NYSEARCA: FAS ). However, the government reimburses Lockheed for pension costs using Cost Accounting Standards (NYSE: CAS ). This means that Lockheed’s pension costs and its pension reimbursements do not always match up. Some years these differences can be negligible but other years they can be enormous. In 2011 Lockheed Martin recognized a FAS pension expense of $1,821M and received a CAS pension reimbursement of $899M meaning the company recognized $922M in net pension expenses. Lockheed reported $2,667M in net income or $7.90 per share for FY2011. During FY2011 Lockheed’s stock traded at an average of approximately $74 per share so the company would have had a P/E ratio of 9.3. Looks pretty cheap right? Well, it was even cheaper at the time. The actual earnings power of Lockheed’s business was really the $2,667M in reported net income plus the $922M in pension expenses that would be reimbursed in the future. Lockheed actually earned around $3,589M in true net income for FY2011. With 335.9 shares outstanding Lockheed earned $10.68 per share and had a true P/E of 6.9! It’s no surprise that with Lockheed trading that cheaply its stock has more than doubled since 2011. The table below shows how the true P/E for Lockheed Martin in FY2011 was calculated. Computation of Lockheed’s True P/E in FY2011 FY2011 P/E 9.3 Net income as reported $2,667M Add: FAS/CAS pension adjustment $922M True net income $3,589M Shares outstanding 335.9M True earnings per share $10.68 FY2011 stock price $74 True P/E in FY2011 6.9 Lockheed is just one example. Many companies report onetime non cash charges that can artificially increase a P/E ratio making the stock look more expensive than it is. In our second example we will look at the case of Twenty-First Century Fox (NASDAQ: FOXA ) and an accounting item that makes the stock look cheaper than it is. As of this writing Fox trades at a TTM P/E of 7.77. The stock looks extremely cheap. However, in November of 2014 (part of Fox’s FY2015) the company sold its interest in Sky Italia and Sky Deutschland. That along with several other transactions netted Fox a onetime gain of approximately $4.2B. Fox reported net income of $8,306M for FY2015. After backing out the onetime gains Fox really earned $4,110M in net income for FY2015. With 2.04B shares outstanding and a share price of approximately $30 Fox’s true P/E is really 14.85. Fox still looks cheap, but not quite as cheap as first glance. The table below shows how the true P/E was calculated. Computation of Fox’s True P/E TTM P/E (for reference) 7.77 Net income as reported $8,306M Less: One time gain $4,200M True net income $4,110M Shares outstanding 2039 True earnings per share $2.02 Current price $30 True P/E 14.85 These are just some of the many examples of ways that the accrual accounting based earnings that companies report may not accurately reflect their true earnings and how P/E ratios widely reported by many financial data sites may be technically correct but inaccurate for assessing the true cheapness or “expensiveness” of a stock. One way to avoid some of the accounting rules based pitfalls of the P/E ratio is to use the Price to Free Cash Flow ratio. Price to Free Cash Flow The Price to Free Cash Flow ratio uses a company’s free cash flow (cash flow from operations less capital expenditures). Free cash flow offers several advantages over the P/E ratio. First and foremost it’s based on cash accounting which only counts income or expenses when cold hard cash is received or paid out. That means noncash items like restructuring charges or impairment charges are ignored. Items like onetime gains from the sale of investments such as Fox’s sale of Sky Italia and Sky Deutschland show up in cash flows from investments, not operations, and thus are not included in a company’s free cash flow number. One major disadvantage of using free cash flow is that free cash flow numbers tend to be lumpy and uneven due to timing issues surrounding the company’s cash payments and receipts and changes in a company’s working capital levels. This may make a stock look expensive some years and cheap other years solely based on a company’s working capital changes. For example the table below shows W.W. Grainger’s (NYSE: GWW ) net income, free cash flow as reported, and free cash flow before working capital changes. In $000s FY2014 FY2013 FY2012 Net Income $801,729 $797,036 $689,881 Free Cash Flow $709,954 $789,556 $689,071 Free Cash Flow Before Working Capital Changes $876,696 $850,675 $815,675 As you can see Grainger’s working capital changes produce large fluctuations in cash flows. Net income has risen each year but free cash flow has bounced around, rising and then falling. When you back out the effect of working capital changes you can see that free cash flow is far from lumpy, instead it has increased each year just like Grainger’s net income. Simply backing out all working capital fluctuations would be a quick and dirty method to produce smooth cash flows for your free cash flow calculation. However, as most companies grow they require additional working capital so we should try to do something to take that into account. The table below shows Grainger’s working capital changes for each year. In $000s FY2014 FY2013 FY2012 FY2011 Working Capital $1,705,833 $1,848,495 $1,820,637 $1,306,975 YoY Change -$142,662 $27,858 $513,662 In FY2014 and FY2013 working capital barely changed, and if you look at Grainger’s net income you will see it why. Net income barely increased so the company’s working capital needs stayed the same. In FY2012 working capital increased by more than $500M, likely to support FY2013’s large increase in net income compared to the previous year. Since Grainger is growing slowly now we do not need to make any working capital adjustments for our calculations. However, if you were producing free cash flow projections for a discounted cash flow model and projecting growing sales you would want to include a deduction to represent increasing working capital needs. I’d recommend looking at a company’s historical working capital levels and using some sort of average or median figure to model as your increase. Now back to calculating Grainger’s Price to Free Cash Flow. For our purposes we will term our working capital modified numbers “adjusted free cash flow”. Since Grainger does not have any working capital adjustments due to slowing growth the calculation is relatively simple as you can see below. We just take the current market cap divided by our adjusted free cash flow number to get the price to free cash flow ratio (and the inverse to get the free cash flow yield). Grainger’s Price to Free Cash Flow Adjusted Free Cash Flow $876.696M Market Cap $15,200M Price to Adj. Free Cash Flow 17.34 Adj. Free Cash Flow Yield 5.77% While price to free cash flow with working capital adjustments gives you a much more accurate valuation number then the P/E it’s a bit complicated to calculate and you have to make some estimates about working capital. While it fixes most of the flaws of the P/E ratio it still has one problem. It tells you nothing about a company’s debt load. Enter the EV/EBITDA ratio. EV/EBITDA Ratio The EV/EBITDA ratio is widely used because it includes the company’s debt load in the valuation as well. It also better Enterprise Value is the market value of the company’s equity plus the book value of its long term debt. EBITDA stands for E arnings B efore I nterest T axes D epreciation and A mortization. EBITDA is sometimes derisively referred to as “earnings before all the bad stuff” among accounting focused investors but there are good reasons for using it. EBITDA excludes interest charges which are not part of a company’s underlying business. Interest charges represent the financing decision of the company. Furthermore we account for debt levels by using the enterprise value rather than equity value. Taxes also do not reflect the earnings power of a business; instead taxes probably better reflect the lobbying power of the industry the business operates in. Some businesses like IBM pay almost no federal taxes while others like Paychex pay close to the statutory maximum of 35%. Depreciation and amortization are also excluded because those charges represent accounting decisions then business decisions (e.g. the accounting rules for calculating the useful life of a capital asset to compute depreciation charges). Note: Beware of “Adjusted EBITDA” Wall Street and company CFOs have taken the concept of EBITDA even further and many companies report something called “adjusted EBITDA” which varies from company to company based on what charges they want to exclude. Adjusted EBITDA usually really does resemble the accounting joke of “earnings before all the bad stuff”. When you see adjusted EBITDA I would avoid using that number like the plague unless there is a very good reason for the company adjusting the number such as a onetime gain on the sale of a business or a onetime payment such as the tobacco companies’ billion dollar settlements with the IRS a few years ago. Let’s continue with our example of W.W. Grainger to see how calculating the EV/EBITDA ratio works. As the table below shows we take the market value of the equity and add the book value of debt (I’m using FY2014 numbers for all calculations). That gives us $15.2B in equity plus $405M in debt for an enterprise value of $15.6B. To calculate EBITDA we start with Grainger’s net income of $802M and add back $8M in net interest payments, $522M in taxes, and $208M in depreciation which gives us EBITDA of $1.54B. Grainger’s EV/EBITDA Ratio Market Value of Equity $15,200M Book Value of Long term Debt $405M Enterprise Value $15,605M Net Income (Earnings) $802M Interest $8M Taxes $522M Depreciation and Amortization $208M EBITDA $1,540M EV/EBITDA Ratio 10.13 Now it’s worth noting that since EBITDA excludes many charges the numbers will be higher than both earnings and free cash flow and as such industry average EV/EBITDA ratios will always be lower than their respective P/E and free cash flow ratios. The Final Verdict The simple P/E ratio has too many flaws to make it useful. The EV/EBITDA ratio stands head and shoulders above the other metrics in giving investors a comprehensive valuation of a company’s underlying business. However, because it uses accrual accounting numbers from the companies income statement it can be vulnerable to manipulation and does exclude some costs. I favor using the EV/EBITDA ratio and then cross checking it with adjusted free cash flow information to make sure nothing funny is going on with a company’s numbers and to get a comprehensive look at a companies valuation. Disclosure: I am/we are long LMT. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
