Saturday, June 23, 2007

EBITDA multiples | Morgan Stanley

So far, we’ve talked a lot about multiples: You’ve mentioned EBITDA
multiples in your discussion of the analysis you did at Morgan Stanley,
you’ve talked about P/E multiples in your analysis of a common stock. I
wondered if you could tell me what a multiple really is—to say that a
company is trading at “8x.” How would I make sense of that? How is that
meaningful to you? What does it tell you about the company?
One surefire way to separate the recruiting wheat from the chaff is to ask a candidate to take a
step back and translate technical lingo into good old-fashioned English. Our recruiting insiders
report that they’re often staggered by the number of candidates who expect that their deft use of
financial terminology will itself win them the job. Particularly among MBA candidates,
questions often enable interviewers to distinguish those who simply interview well from those who
are intellectually challenged by (and interested in) financial analysis.
Bad Answer
Candidate: Well, EBITDA multiples are more widely used in some industries,
and P/E multiples are more prevalent in others. They’re both pretty subjective,
and sometimes it just comes down to whether the research analysts who cover
the sector use one or the other as their primary metric. But if someone’s trading
at “8x,” it just means the total enterprise value of the company is eight
times its EBITDA, obviously. I think in general, 8x EBITDA is pretty cheap.
There are plenty of companies with P/Es of 20x or 30x or more—think about
the valuations during the Internet boom.
This answer misses the point. Valuation is all relative, and you need to understand what information
is being conveyed by a given multiple. Again, this is a quantitative question—don’t answer
with a qualitative allusion to research analysts and their ability to move markets with their
insight. The notion that some industries focus on EBITDA multiples and others on P/E is also
naïve—theoretically, the markets have good reasons for focusing on one metric or the other. If
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anything, you should look at both the EBITDA multiple and the P/E multiple together when
comparing the valuations of two businesses. This process will tell you more than either one in
isolation. In any case, there is no way you can make a blanket statement that “8x” represents a
low valuation. It may or may not, depending on the company and industry in question.
Mediocre Answer
Candidate: Well, if a company is trading at 8x EBITDA (for example), you
would want to look at where other similar companies trade to figure out which
companies are better-liked by the markets. Also, you might figure out whether
8x constitutes a higher or lower multiple than where this company has traded
over time. It might be that at 8x EBITDA, a company is undervalued because it
normally trades at over 10x EBITDA, which would represent a buying opportunity.
In terms of EBITDA versus P/E multiples, P/E tends to be used more
for companies that actually have net income. In some industries, particularly
younger or growing sectors like technology, companies are still losing money
and so P/E multiples aren’t relevant or meaningful. In that case, you’d want to
look at cash flow and thus EBITDA multiples would be the best metric.
This is a better answer, in that it points out that multiples only provide information on a
relative basis. Where is a company trading today versus yesterday? Where does it trade
relative to its peers? Multiples are useful in assessing relative—as opposed to absolute—value.
The candidate’s point about P/E multiples, however, leaves a little bit to be desired. It’s all
well and good to point out that if you have no earnings (the “E” in P/E), then it’s no use
looking at P/E multiples. However, there are some critical distinctions between EBITDA
and P/E multiples for those companies who do have positive earnings. Most importantly, two
businesses in an industry with the same EBITDA might have different earnings because one
has more debt and thus pays more interest expense. Taking on more debt is a financing
decision, not an operating decision, and so the fact that the companies’ bottom-line earnings
differ doesn’t necessarily imply that one business is performing better or generating more real
operating profit than the other.
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Good Answer
Candidate: Fundamentally, a multiple is an indication of how an investor (or a
market) values the earning potential of a given enterprise. Mathematically, it’s a
ratio of a valuation metric (such as market capitalization or the purchase price
in an acquisition) divided by financial performance, whether measured by sales,
EBITDA, free cash flow, or net income. So breaking it down even further, the
ratio tells you that for every dollar of, say, earnings, an investor (or the public
markets) has assigned a particular value to that dollar of earnings.
Interviewer: That’s a good starting point, but what does that number tell you?
How do I make sense of that?
Candidate: In isolation, the multiple tells you very little. The multiple is most
useful when you are comparing the value of the company in question with the
value of similar businesses. As I mentioned earlier, a multiple gives you the
number of dollars an investor (or a public market, which is just a collection of
investors) would pay for a given unit of financial performance, however you’ve
chosen to define it. So when you compare two similar businesses in the same
industry, and one—we’ll call it Company A—trades for 10x earnings and the
other—Company B— trades for only 8x earnings, this tells you that the market
for whatever reason values each dollar of Company A’s earnings more than
Company B’s.
Interviewer: Okay, this is a good start, but to make it easier, why don’t we
discuss two specific companies rather than two hypothetical enterprises? Let’s
compare Lowe’s and Home Depot. These are both public companies, and they
operate in the same competitive space. However, Home Depot trades at 9x
EBITDA, and Lowe’s trades at 11x EBITDA. What does this tell you about
Lowe’s versus Home Depot?
Candidate: It tells you that the market values each dollar of Lowe’s earnings
more than Home Depot’s.
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Interviewer: Right—but we covered that when we talked about Company A
versus Company B. My question is why? Why might the market assign two
different values for these specific companies’ earnings, when they’re in the same
exact industry?
Candidate: Well, it should tell you something about the quality of those
earnings. The market may believe that Lowe’s is better positioned to grow its
earnings than Home Depot, or perhaps it believes that Lowe’s earnings are
likely to be less volatile or more predictable for some reason. In general, the
market will be willing to pay more for each dollar of a company’s earnings if it
believes that those earnings have either more growth potential or more stability
than those of its competitors.
Interviewer: So given that the markets value Lowe’s more highly today, which
stock represents the better buy? In other words, which would you choose if you
could buy either one?
Candidate: Wow, that’s a tough one. After all, if you believe in efficient
markets, then you would say both companies are valued fairly. In other words,
Lowe’s may be more expensive today, valued at 11x last year’s EBITDA, vs.
Home Depot at 9x last year’s EBITDA, but if both businesses grow as expected,
then today’s valuation might be exactly the same for both companies—as a
multiple of future EBITDA. So I don’t think the multiple differential today
necessarily tells you which company is a better value today.
But, if I had to answer your question, given that both companies are in the
same business fundamentally, I would question whether Lowe’s really will grow
measurably faster than Home Depot. In any event, that growth is completely
“on the come,” whereas last year’s (trailing) EBITDA is in the bag. I think
Home Depot is the market leader, and is a better value on actual trailing
EBITDA today, so I would probably go with them.
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The conclusion above is thoughtful and defensible, but the candidate could just have easily
defended selecting Lowe’s. You might conclude that Lowe’s is still building new stores and
expanding nationwide, and that you’d rather back a growing business, whereas a more mature
number-one player like Home Depot that already has stores everywhere might have a tougher
time finding ways to increase profits. If you really believe in efficient markets, there’s no right
answer to the question of which company is the better buy. The point is, have good reasons for
your point of view, and at a minimum, make sure to have a point of view!
Interviewer: But why EBITDA multiples? Is that the right metric for this
Candidate: Well, in this case I think it’s a safe bet that both businesses have
similar capital expenditure and working capital requirements, so EBITDA is
probably a fair back-of-the-envelope metric for comparing operating cash flow.
I don’t know whether one company has more debt (and thus more interest
expense) than the other, so I don’t know whether the P/E multiples are truly
Interviewer: Can you think of a hypothetical scenario where EBITDA
wouldn’t be a good valuation metric for comparing two businesses in the same
Candidate: One example comes to mind. When I worked at Morgan Stanley, I
completed a comparable transaction analysis involving acquisitions in the food
industry. Two similarly sized companies that were equally profitable had been
purchased for 5x EBITDA. If you relied only on the EBITDA multiples, you’d
conclude that the two buyers paid similar purchase prices: after all, same
EBITDA, same purchase price multiple, same industry. But in this case, EBITDA
was misleading and not at all equivalent to cash flow. These were both food
companies, but one manufactured chilled dairy products—primarily milk and
ice cream—while the other company manufactured shelf-stable, canned foods.
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The first company required much higher annual capital expenditures because
chilled dairy products require more expensive equipment for their storage and
transportation. The canned food company had much lower capex because its
products could sit on a truck or in a warehouse for an eternity without spoiling.
The significant difference in capex wasn’t reflected in the EBITDA multiple.
Therefore, the buyer of the chilled dairy business paid a significantly higher
price than the buyer of the ambient food business, even though the EBITDA
multiples were the same.
It should be clear that this candidate clearly gets it. Multiples can be deceptive, and should not
be viewed in isolation, but they can provide a wealth of information about how the markets
value a business, and why. The key in the interview is to keep it quantitative—after all, a
multiple is a fraction!

1 comment:

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